Page 268 - DECO402_Macro Economics

Unit-30: Rational Expectations Hypothesis

Notes

Notes Thought of rational hypothesis was first presented by John Mooth in 1961, who
had taken this thought from engineering literature.

In recent years economists in model development have made an extensive use of adaptive expectation
hypothesis. In this relation work done by Cagen in 1956 and by Nerlove in 1957 was very important.
According to adaptive expectations hypothesis, it is the expectation of the financial agents that future
will also definitely be like the tendencies of the past. They expect future prices of economic variables like
price income in form of average of their past prices and the change in them to be in a very slow speed.
Financial agents make the expected prices of these variables equal to the weighted average of their
past and present prices. They change their expectations according to previous forecast errors. Errors
that took place as a result of previous behaviours point towards an important source of information
for development of hypothesis. But such expectations are based on these assumptions that financial
agents expect very little change to take place on those mistakes. Hence when there are changes in
economic policy then often meaningless forecasts happen through it.
For example, according to adaptive expectation hypothesis, financial agents develop the expectations
of future inflation rate by the weighted average of the average inflation rates experienced earlier and
if actual inflation is about to be different from expected inflation then they revise those expectations
from time to time. It expresses the irrational behaviour of financial agents. Freidman’s analysis of long-
term Philips curve is based on adaptive expectation hypothesis. Assumption hidden in acceleration
hypothesis of Friedman that price expectations are primarily based on experience of previous inflation
is unrealistic. When price expectations of the financial agents are based on this assumption then they
are irrational. If they think so in situation of rising prices, they will find themselves to be wrong.
Its reason is that development of hypothesis is done not only by previous projections but by direct
forecasts of future also. Basis of people’s expectations is previous price changes along with present
information in relation to many factors. In this manner, rational people for forecasting the inflation
of the future with more reality, make use of all available information.

Self Assessment
Fill in the Blanks:
1. When there are changes in economic policy then often meaningless ............ happen through
it.
2. Ratex Hypothesis is applied to ................ policy.

30.2 Rational Expectations

Thought of rational expectations was first presented by John Mooth in 1961, who had taken this thought
from engineering literature. His model is about modelling price activities of the main market. If we
move with the assumption that financial agents, at the time of developing expectations, make the
skilled and most desired use of information, then they create such theory of expectations by which
reaction of consumers and producers on expected price changes depends on their reaction on actual
price changes. Mooth’s saying is that some expectations are rational in these meanings and that
incidents are different only because of some random mistake only.
Mooth’s imagination of rational expectations is related to microeconomics. Many economists were not
satisfied by it. Hence it remained inactive for ten years. During the beginning of the decade of 1970,

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