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The Rational Expectations Hypothesis!
Introduction:
In the 1930s when Keynes wrote his General Theory, unemployment was the major problem in the world. During the Second World War, inflation emerged as the main economic problem. In the postwar years till the late 1960s, unemployment again became a major economic issue. From the late 1960s to 1970s, a new phenomenon appeared in the form of both high unemployment and inflation, known as stagflation.
This phenomenon of stagflation posed a serious challenge to economists and policy makers because the Keynesian theory was silent about it. Out of this crisis emerged a new macroeconomic theory which is called the Rational Expectations Hypothesis (Ratex).
Rational Expectations:
The idea of rational expectations was first put forth by Johy Muth in 1961 who borrowed the concept from engineering literature. His model dealt mainly with modelling price movements in markets. By assuming that economic agents optimise and use information efficiently when forming expectations, he was able to construct a theory of expectations in which consumers’ and producers’ responses to expected price changes depended on their responses to actual price changes. Muth pointed out that certain expectations are rational in the sense that expectations and events differ only by a random forecast error.
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Muth’s notion of rational expectations related to microeconomics. It did not convince many economists and lay dormant for ten years. It was in early 1970s that Robert Lucas, Thomas Sargent and Neil Wallace applied the idea to problems of macroeconomic policy.
Basic Propositions of the Rational Expectations Hypothesis:
The Ratex hypothesis holds that economic agents form expectations of the future values of economic variables like prices, incomes, etc. by using all the economic information available to them. This information includes the relationships governing economic variables, particularly monetary and fiscal policies of the government. Thus the rational expectationists assume that economic agents have full and accurate information about future economic events.
According to Muth, information should be considered like any other available resource which is scarce. Further, rational economic agents should use their knowledge of the structure of the economic system in forming their expectations. Thus the Ratex hypothesis “presumes that individual economic agents use all available and relevant information in forming expectations and that they process this information in an intelligent fashion. It is important to recognise that this does not imply that consumers or firms have “perfect foresight” or that their expectations are always “correct”.
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What it does suggest is that agents reflect upon past errors and, if necessary, revise their expectational behaviour so as to eliminate regularities in these errors. Indeed the hypothesis suggests that agents succeed in eliminating regularities involving expectational errors, so that the errors will on the average be unrelated to available information.”
The Ratex hypothesis has been applied to economic (monetary, fiscal and income) policies. The rational expectationists have shown the short-run ineffectiveness of stabilisation policies. According to them, no one knows much about what happens to the economy when economic (monetary or fiscal) policy is changed. Specifically, it means that macroeconomic policies designed to control recession by cutting taxes, increasing government spending, increasing the money supply or the budget deficit may be curbed.
They argue that the public has learnt from the past experience that the government will follow such a policy. Therefore, the government cannot fool the people by adopting its effects and mere signs of such a policy in the economy create expectations of countercyclical action on the part of the public. Thus, according to the Ratex hypothesis, people form expectations about government monetary and fiscal policies and then refer to them in making economic decisions.
As a result, by the time signs of government policies appear, the public has already acted upon them, thereby offsetting their effects. In other words, the Ratex hypothesis holds that the only policy moves that cause changes in people’s economic behaviour are those that are not expected, the surprise moves by the government. Once the public acquires knowledge about a policy and expects it, it cannot change people’s economic behaviour. We discuss some of the policy changes in the light of the Ratex hypothesis below.
Rational Expectations and the Phillips Curve:
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In the Friedman-Phelps acceleration hypothesis of the Phillips curve, there is a short-run trade-off between unemployment and inflation but no long-run trade-off exists. The reason is that inflationary expectations are based on past behaviour of inflation which cannot be predicted accurately.
Therefore, there is always an observed error So that the expected rate of inflation always lags behind the actual rate. But the expected rate of inflation is revised in accordance with the first period’s experience of inflation by adding on some proportion of the observed error in the previous period so that the expected rate of inflation adjusts toward the actual rate.
Economists belonging to the rational expectations school have denied the possibility of any trade-off between inflation and unemployment even during the long run. According to them, the assumption implicit in Friedman’s version that price expectations are formed mainly on the basis of the experience of past inflation is unrealistic.
When people base their price expectations on this assumption, they are irrational. If they think like this during a period of rising prices, they will find that they were wrong. But rational people will not commit this mistake. Rather, they will use all available information to forecast future inflation more accurately.
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The rational expectations idea is explained diagrammatically in Figure 1 in relation to the Phillips curve. Suppose the unemployment rate is 3 per cent in the economy and the inflation rate is 2 per cent. We start at point A on the SPC1 curve.
In order to reduce unemployment, the government increases the rate of money supply so as to stimulate the economy. Prices start rising. According to the Ratex hypothesis, firms have better information about prices in their own industry than about the general level of prices.
They mistakenly think that the increase in prices is due to the increase in the demand for their products. As a result, they employ more workers in order to increase output. In this way, they reduce unemployment. The workers also mistake the rise in prices as related to their own industry. But wages rise as the demand for labour increases and workers think that the increase in money wages is an increase in real wages.
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Thus the economy moves upward on the short-run Phillips curve SPC, from point A to B. But soon workers and firms find that the increase in prices and wages is prevalent in most industries. Firms find that their costs have increased. Workers realise that their real wages have fallen due to the rise in the inflation rate to 4 per cent and they press for increase in wages.
Thus the economy finds itself at the higher inflation rate due to government’s monetary policy. As a result, it moves from point B to point C on the SPC2 curve where the unemployment rate is 3 per cent which is the same before the government adopted an expansionary monetary policy. When the government again tries to reduce unemployment by again increasing the money supply, it cannot fool workers and firms who will now watch the movements of prices and costs in the economy. If firms expect higher costs with higher prices for their products, they are not likely to increase their production, as happened in the case of the SPC, curve.
So far as workers are concerned, labour unions will demand higher wages to keep pace with prices moving up in the economy. When the government continues an expansionary monetary (or fiscal) policy, firms and workers get accustomed to it.
They build their experience into their expectations. So when the government again adopts such a policy, firms raise prices of their products to nullify the expected inflation so that there is no effect on production and employment.
Similarly, workers demand higher wages in expectation of inflation and firms do not offer more jobs. In other words, firms and workers build expectations into their price policies and wage agreements so that there is no possibility for the actual rate of unemployment to differ from the natural rate, N, even during the short run.
Its Policy Implications:
The Ratex hypothesis assumes that people have all the relevant information of the economic variables. Any discrepancy between the actual rate of inflation and the expected rate is only in the nature of a random error. When people act rationally, they know that past increases in prices and the rate of change in prices have invariably been accompanied by equal proportional changes in the quantity of money.
When people act on this knowledge, it leads to the conclusion that there is no trade-off between inflation and unemployment even in the short-run. It implies that monetary (or fiscal) policy is unable to change the difference between the actual and natural rate of unemployment. This means that the economy can only be to the left or right of point N of the long-run Phillips curve IPC (in Figure 1) in a random manner. Thus the implication is that stabilisation policy is ineffective and should be abandoned.
Its Criticisms:
The Ratex hypothesis has been criticised by economists on the following grounds:
1. Unrealistic Assumption:
The assumption of rational expectations is unrealistic. The critics argue that large firms may be able to forecast accurately, but a small firm or the average worker will not be able to do so.
2. Costly Information:
It costs much to collect, distill and disseminate information. So the market for information is not perfect. Therefore, the majority of economic agents cannot act on the basis of rational expectations.
3. Different Information’s:
The critics also point out that the information available to the government differs from that available to firms and workers. Consequently, expectations of the latter about the expected rate of inflation need not necessarily be diverse from the actual rate only by the random error. But the government can accurately forecast about the difference between the expected inflation rate and actual rate on the basis of information available with it. Even if both individuals and government have equal access to information, there is no guarantee that their expectations will be rational.
4. Prices and Wages not Flexible:
Critics point out that prices and wages are not flexible. Economists like Philips, Taylor and Fischer have shown that if wages and prices are rigid, monetary or fiscal policy becomes effective in the short-run. The rigidity of wage rates implies that they adjust to market forces relatively slowly because wage contacts are binding for two or three years at a time.
Similarly, the expected price level at the beginning of the period is expected to hold till the end of the period. Thus even if expectations are rational, monetary or fiscal policy can influence production and unemployment in the short-run.
5. Expectations Adaptive:
Gordon rejects the logic of the Ratex hypothesis entirely. He assigns two reasons for this: first, individuals do not know enough about the structure of the economy to estimate the market clearing price level and stick with adaptive expectations; and second, if individuals gradually learn about the structure of economic system by a least-squares learning method, rational expectations closely approximate to adaptive expectations.
6. Government not Impotent:
It is generally said that according to the Ratex hypothesis, the government is impotent in the economic sphere. But the Ratex economists do not claim this. Rather, they believe that the government has a tremendous influence on economic policies.
Stabilisation Policy and Ratex Hypothesis:
According to the Ratex hypothesis, monetary and fiscal (stabilisation) policies are ineffective even in the short-run because it is not possible to anticipate accurately how expectations are formed during the short-run. This is called “policy impotence.”
The Ratex hypothesis is based on the assumption that consumers and firms have accurate information about future economic events. Their expectations are rational because they take into account all available information, especially about expected government actions.
If the government is following any consistent monetary or fiscal policy, people know about it and adjust their plans accordingly. So when the government adopts the expected policy measure, it will not be effective because it has been anticipated by the people who have already adjusted their plans. This means that government policy is ineffective. Another important assumption is that all markets are fully competitive and prices and wages are completely flexible.
Let us first take fiscal policy. The Keynesians advocate an “activist” fiscal policy to reduce unemployment. But, according to the Ratex hypothesis, a tax cut and/or increase in government spending will reduce unemployment only if its short-run effects on the economy are unexpected (or unanticipated) by people.
In other words, an expansionary fiscal policy may have short-term effects on reducing unemployment provided people do not anticipate that prices will rise. But when the government persists will such a policy, people expect the rate of inflation to rise.
So the workers will press for higher wages in anticipation of more inflation in the future and firms will raise the prices of their products in anticipation of the rise in future costs. As a result, fiscal policy will become ineffective in the short-run. It may cause more unemployment and inflation in the long-run when the government tries to control inflation.
Similarly, if the government adopts an expansionary monetary policy by increasing the money supply to reduce unemployment, it is also ineffective in the short-run. Such a policy may reduce unemployment, in the short-run provided its effects on the economy are unanticipated. But when the government persists with such an expansionary monetary policy, people expect the inflation rate to rise. Firms raise the prices of their products to overcome the anticipated inflation so that there is no effect on production. Similarly, workers press for higher wages in anticipation of inflation and firms do not employ more workers. So there is no effect on employment.
Thus the Ratex hypothesis suggests that expansionary fiscal and monetary policies will have a temporary effect on unemployment and if continued may cause more inflation and unemployment. For such policies to be successful, they must be unanticipated by the people.
Once people anticipate these policies and make adjustments towards them, the economy reverts back to the natural rate of unemployment. Thus for expansionary fiscal and monetary policies to have an impact on unemployment in the short-run, the government must be able to fool the people. But it is unlikely to happen all the time. If the government continues to persist with such policies, they become ineffective because people cannot be fooled for long and they anticipate their effects on production and unemployment.
Thus fiscal-monetary policies become ineffective in the short-run. According to the advocates of the Ratex hypothesis, inflation can be controlled without causing widespread unemployment, if the government announces fiscal and monetary measures and convinces the people about it and do not take them be surprise.
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