Fooling Model Econ101
Popular in Principles of Macroeconomics
Popular in Macro Economics
This 5 page Class Notes was uploaded by savills on Friday September 23, 2016. The Class Notes belongs to Econ101 at Arizona State University taught by Dr. Kristen Kling in Fall 2016. Since its upload, it has received 3 views. For similar materials see Principles of Macroeconomics in Macro Economics at Arizona State University.
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Date Created: 09/23/16
Friedman’s fooling model is a marketclearing model. It implies that firm operates on the demand for labor and workers operate on their supply of labour. Workers have backwardlooking or adaptive expectations. They are assumed to have inelastic price expectations. They look at the current actual price level and at their previous price expectations to generate a future expected price. If P = P then SA E L= D L The market clearing model will be in disequilibrium if expectations are incorrect but will adjust to equilibrium as expectations adjust. Suppose there is an increase in AD (AD to AD ) via an0expansio1ary monetary policy. This caused an increase in output (Y to Y ) and0an inc1ease in P (P to P ). A 0 1 Increased in output requires an increase in labour. Therefore, employers need to increase nominal wage to hire more workers. But the increase in nominal wage must be less than the increase in P (i.e. A < P ) so1that 1eal wage decreases (W /P < 1 1 W /0 )0for firms to hire the extra workers needed (L to L ) to inc0ease t1e output. Workers on the other hand, see the increase in nominal wage as an increase in expected real wage because they are unaware of the price increase (i.e. W > P so that 1 0 W /P > W /P ). Therefore they expect the correct prices to continue on into the future. 1 0 0 0 So workers are fooled and supply of labour increases to provide the workers (L to L ) 0 1 to increase output. When workers realize that their real purchasing power has in fact declined despite the nominal wage increase, they adjust their price expectations from P to P and demand 0 1 a nominal wage from W to W to m1tch the 2rice increase. Therefore real wage returns to its market clearing level (i.e. W /P = W /P2). 1RAS sh0fts0left due to the higher wage costs [SRAS(P *) to SRAS(0 *)] where it inte1sects the LRAS at the actual price level (P ). 1 The adjustment process takes us to W /P 2 1 and L in0 he labour market but P and Y in 1 0 the output market. But at P , AD > SRA1(P *), 1o there is a ne1d for Y and P to rise again. The eventual adjustment process must mean that SRAS shifts to the left by the same amount as the original rightward shift of AD. Therefore, this process will only end when expectations are fully adjusted. Both markets are in equilibrium with D = S at L L L 0and output back at Y = Y.0This LfAS curve is often referred as the correct expectation line. The Fooling model provides a theory of the business cycle where there can be protracted periods of time in which Y ≠ Y because ff incorrect information. It also explain the impact of a change in the money supply on P and Y. In the short run both P and Y change but in the long run, the impact is only on P. The policy implications for the Fooling model is that in the short run, shifts in AD through changes in money supply affect output and employment. In the long run, however, a higher rate of money growth eventually translates one for one into a higher rate of inflation.