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BPEA Article

Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment

Abstract

THE INTERACTION OF EXPECTED INFLATION and nominal rates of interest is a topic that has received its share of attention since Milton Friedman gave Irving Fisher's theory a prominent role in his presidential address to the American Economic Association in 1967. The relationship between interest and expected inflation depends intricately on the interactions of the real and financial sectors of the economy, so that the subject of this paper lies in the domain of macroeconomic analysis. Partial equilibrium analysis won't do. Therefore, even though my main subject is the relationship between interest rates and expected inflation, there is no way to avoid such matters as the nature of the Phillips curve, the way expectations are formed, and, in some formulations, the sizes of various interest elasticities: those of the demand and supply for money and those of aggregate demand and its components.

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