According to Lucas' rational expectations approach, what will happen if the Fed announces and implements a 4% decrease in money supply?
A)output will remain unchanged but the price level will decrease by 4% in the long run
B)both output and the price level will decrease by more than 4% in the short run and by 4% in the long run
C)output and the price level will both decrease in the short run, but only output will change by 4% in the long run
D)output will decrease by 4% and the price level will initially remain the same but will decrease by 4% as people change their expectations
E)output and the price level will both immediately decrease by 4%

Question

Quizplus · Accepted Answer

According to Lucas' rational expectations approach, if the Fed announces and implements a 4% decrease in money supply, people will adjust their expectations accordingly and anticipate a 4% decrease in the price level in the long run. In the short run, both output and the price level may decrease by more than 4% due to nominal rigidities (such as sticky prices), but in the long run, output will return to its natural level and the price level will decrease by 4% as expected. Therefore, choice A is the best answer.

According to Lucas' Rational Expectations Approach, What Will Happen If