(DP 1987-01) Interpreting the Basic Rational Expectations Macroeconomic Model

Abstract

The conclusion that systematic monetary policy is ineffective seems necessary in the basic rational expectations macroeconomic model. This rests on an implicit normalization that puts the natural employment level Ln at the classical full employment point which interpretation, however, requires irrational workers. A more self-consistent interpretation defines Ln in terms in terms of the condition that production meets demand at the going price while firms maximize expected profit. The resulting implications are closer to standard Keynesian theory: fully anticipated monetary policy can, and fully anticipated demand changes must, affect output and employment.