Rational Expectations Theory
The
Rational Expectations Hypothesis (REH) emerged to deal with the weaknesses of
the Adaptive Expectations Hypothesis (AEH). Rational expectations ensures
internal consistency and assumes the model’s predictions are valid. This
assumption is used especially in many Macroeconomic models. Rational
expectations differs from rational choice under uncertainty. This way of
modelling was first outlined by John F. Muth in 1961 but later became popular
when it was used by Robert Lucas[1].
The
Rational Expectations theory says that economic agents use all the information
available to them in forecasting the future. If their forecast proves to be
wrong they suffer a loss of utility and fail to maximize their return. They
have, therefore an incentive to obtain more and better information so that the
mistakes are not repeated. It is true that forecast or decisions of economic
agents are not always based on accurate information but their errors will not
be systematic.
Lucas questioned the
assumptions behind the Phillips curve, which
had been thought to show that a government can lower the rate of unemployment by increasing inflation. According to the Phillips curve, higher
inflation causes wages to rise more quickly, thereby fooling unemployed
workers into thinking that the higher nominal wages are generous when, in fact,
they are simply inflation-adjusted wages. Therefore, the unemployed take jobs
more quickly, and the unemployment rate falls.
Defining
Rational Expectations:
Since the publication of the seminal article on
rational expectations (RE) by John Muth (1961), a variety of definitions have
been proposed for this concept. Although a definitions cannot be wrong, some
ways of definitions things can be more fruitful than others. There are two
possible sort of definitions one weak and one strong.
Under the weak-form definitions of RE, the concept of RE
essentially reduces to an assumption that agents make optimal use of whatever
information they have to form their expectations. This is viewed by many
economists as a natural extension of the usual postulate in economic theory
that - unless there is good empirical evidence to the contrary one should
presume that agents will always strive to bring their expectations into
consistency with their information. Under strong form of RE economic agents are
generally presumed to have a great deal more information than would actually be
available to any econometrician who test these models on the basis of data.
Assumptions:
The
RE theory is based on the following Assumptions:
1. The errors therefore are not
systematic. Forecasts are made on the basis of a correct model of the economy.
In the course of correcting past and current mistakes we may overshoot so that
our response is greater than it would be if we has perfectly accurate
information. RE theory assumes that errors we make in any one period or one
decision will be randomly distributed, in an assumed normal distribution.
2. Economic agents (People)
understand the Natural Rate of Unemployment (NRU) and have other relevant
information about the economy.
3. On the basis of Weak version
of the theory people immediately realise the impact of government decision and
forecasts future rate of inflation on the basis of growth in money supply
announced by the government.
4. People understand how the government
manipulates its monetary policy whenever unemployment rises above NRU and
immediately revise their expectations of inflation accordingly.
5. Rational Expectations theory
assumes that labour markets always clear and the level of output and employment
would always be at the NRU.
6. It is the expected real wage
not the actual real wage which determine the labour market decisions. The
experience teaches them to avoid systematic errors.
7. All economic agents might not
be making mistakes and experience long run increase in real wages following
increase in money supply. People may realize at a later stage that the increase
was not real but they might continue to remain in the employment. It is
difficult to obtain accurate and correct information.
Policy Implications:
According to this theory the monetary stabilization
policy which follows a systematic rule has no effect on output and employment.
The policy is well anticipated by people who revise their expectations of
inflation accordingly. The entire effect of the policy falls on prices leaving
output and employment unchanged. The main implication of this theory is that in
short run there may be some trade-off between inflation and unemployment but in
the long run there is no impact of the systematic policy. The RE theory assumes
that people change their expectations more quickly and use all available
information in forecasting. This
information includes:
The theory of
rational expectations (RE) is a collection of assumptions regarding the manner
in which economic agents exploit available information to form their
expectations. In its stronger forms, RE operates as a coordination device that
permits the construction of a “representative agent” having “representative
expectations.”[2]
The weak form of the RE goes something like this: People have rational
expectations if their forecast is consistent with the real world they live in.
For weak assumptions economic agents need not be an expert economist. Just on
the basis of their past observance they may predict a policy menu as we have
repeated exposure to such situations in our day to day life.
Conclusion:
Although the
discussion on rational expectations has invited divergent views there is an
appealing acceptance of the theory from a broad range of economists largely
because of its theoretical appeal and perhaps due to lack of better
alternative. Much of the existing evidence significantly implies that the
majority of the agents form adaptive expectations, but there is equally enough
evidence in support of rational expectation hypothesis. For example evidence of
forecast of financial markets prices is often considered to be a reflection of
the market absorption of all the information available hence making capital market
more efficient than other markets. Other markets are still not so perfect and
therefore markets do not clear. There is a little disagreement among modern
economists that people do indeed attempt to anticipate inflation. Keynesians
maintain that reactions to a policy change will be slow and indecisive and
their behavior is entirely rational. They also believe in wage rigidity on
account of many institutional factors. Wages and prices are set in a long-term
contract and cannot be renegotiated frequently. Because of these rigidities,
Keynesians argue that discretionary monetary and fiscal policy should be used
to stabilize the economy.
Whereas in New
Classical macroeconomic model, price surprises affect real output because
people confuse nominal wage and price changes with real wage and relative price
changes. Keynesians believe that people have information on general price
movements and the price surprise may not last long.
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