Answer to Question #123702 in Macroeconomics for nida

Question

The U.S. economy suffered from stagflation problem towards the mid-seventies .To cut the recession short the FED (the U. S Central Bank), regardless of what it was saying,started expanding the money growth (money supply) and this policy became the usual pattern in the U.S. for couple of years following the recession and helped the economy recover from the recession. Afterwards, American economy fell into the problem of relatively high inflation, which became the central issue for the policy makers. And the FED managers declared that they will be quite serious about stopping the inflation.
Now, suppose that, in the USA, people did not believe that the FED was serious about stopping the inflation in 1979, 1980 and1981. How can you reconcile the 1981 - 1982 recession experienced in the United States with the rational expectations approach? Explain clearly through the help of the relevant diagram(s). (Start your explanation assuming that economy is in the long-run equilibrium initially)

Answer 1

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