EXPLAINING OUTPUT-INFLATION TRADEOFFS The relationship between deviations of real GDP from full employment and inflation from its expected level Exists mainly because of the presence of random (unforeseen) fluctuations in aggregate demand For a given level of expected aggregate demand, there is a given Lucas aggregate supply curve. Fluctuations in actual aggregate demand around that expected level trace out a tradeoff along the Lucas aggregate supply curve. Fluctuations in expected aggreg ate demand that are small relative to those in actual aggregate demand create a looser relationship but do not disturb the positive correlation between price and output fluctuations. The slope of the output-inflation tradeoff varies across economies because of the information content in the current price level. In an economy that experiences high and volatile inflation, fluctuations in prices are interpreted as fluctuations in the average level of prices rather than as relative price changes, and the output-inflation tradeoff is steeper. In an economy wi th low and predictable inflation rate, fluctuations in the prices in individual sectors are interpreted as relative price changes, and the output- inflation tradeoff is flatter. The output-inflation tradeoff is not directly visible in the raw data on inflation and real GDP fluctuations because of changes in the expected inflation rate. POLICY IMPLICATIONS OF NEW CLASSICAL MODEL First studied by Thomas Sargent and Neil Wallace Anticipated changes in monetary policy have no effect on employment, output, or any other real variable; only the price level
