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 . Agents anticipate the change in the price level. The resulting simulataneous shifts in AD and AS offset one another, leaving output at Q p and yielding a higher price level at p 2. If the Fed decreases the money supply agents will overestimate and real output will fall below the potential level to Q 1 . This is really an argument against permanently lowering output below the potential level of output and, equivalently, permanently lowering the rate of unemployment below the natural rate of unemployment.