Also, the Fed once again raising the price level to p 2. Given adaptive expctations agents can be systematically fooled into underestimating the price level which means that output can be permanently maintained beyond the potential level of output. But we cannot count on sytematic errors by people for policy purposes. People will eventually catch on. Rational Expectations Applied to AS-AD Consider systematic increases in MS Fed announces an increase in the MS .
People can fully anticipate the changes in the price level.
The increase in the MS increases AD from AD 0 to AD 1 . The change in price expectations shifts AS 0 to AS 1 simultaneously. Output is unchanged at Q p . Same thing happens in the next period. The Fed once again announces that it will increase the MS .