1. Explain the concept of rational expectations. How does this view on how expectation is
formed differ from the assumption that workers formed expectations of current and
future price levels based on past information about prices?

Concept of rational expectations
The rational expectations theory is an economic concept whereby people make choices
based on their rational thinking, available information and past experiences. The theory
suggests that the current expectations in an economy are equivalent to what people think the
future state of the economy will become.

There are three assumptions of rational expectations:
• All economic actors are rationally, they have adequate information, people know that
economic future will reasonably accurate, from that it will give good reaction for
predicted change will occur. Based on the judgement they can control their economic
• The price level and the rate of wages can easily change. Lack of supply of goods will
increase prices, and excess supply leads to lower prices. Overpowering workers will
lower their wages, instead labour shortages will increase their wages.
• All markets are perfectly competitive, and complete information will be known by all
economic actors in different markets
As result of this assumption, the rational expectation theory develops an analysis based
on the principles contained in the microeconomic theory which also stems from the
assumption that buyers, producers, and owners of production factors act rationally in
carrying out their activities. The second assumption is that all types of markets operate
efficiently and can quickly make adjustments the prevailing changes

How does this view on how expectation is formed differ from the assumption that workers
formed expectations of current and future price levels based on past information about
The rational expectations view differs from the earlier assumption because the earlier
assumption held that workers form expectations of current and future prices based on the
information about prices only while the rational economic agents in forming a prediction of the
value of the price level does or use the information of the past behaviour of prices only but all
the relevant available past information.

2. Compare the effect of expansionary monetary policy between the new Classical and
Keynesian on output and employment.

Expansionary monetary policy implemented
• money supply MS increases, interest rate r decreases and aggregate demand AD
• In new classical and Keynesian, government uses this method by assuming the
existence of a fully anticipated increase in MS in the market.
• When there is an increase in the money supply from the expansionary monetary
policy AD will shift to the right AD0 to AD1 which raise the price level from P0 to
P1 and output level from Y0 to Y1 and the equilibrium change.
• Firm increases labour demand, and this shifts the labour demand ND curve to the
right from ND0 to ND1, the nominal wage W increases from WO to W1.
• Because the expected change of money supply, as the MS increases, aggregate
supply AS shifts to the left from AS0 to AS1
• Equilibrium point moves from point B to point A, due to the expected change in MS,
P increases from P1 to P2, output decreases from Y1 back to Y0. NS decreases, and
the curve shifts to the left from NS0 to NS1.
• Equilibrium point changes from e1 to e2, the nominal wage increases from W1 to W2
and the number of workers decrease from N1 back to N0. Price increases from P0 to
P2, while the output and employment remains unchanged.