Page 269 - DECO402_Macro Economics

Macroeconomic Theory

Notes Robert Lucas, Thomas Sargent and Neil Wallace used this thought for the problems of macroeconomics
policies.

Did You Know? Mooth’s imagination of rational expectations is related to
microeconomics.

30.3 Basic Propositions of Rational Expectations Hypothesis

Ratex hypothesis believes that financial agents by using all economic information available with them,
build expectations of future prices of economic variable like prices, income etc. This information
specially incorporates in itself relations related to economic variables like monetary and fiscal policies
of the government. In this way, those building expectations believe that financial agents have complete
and correct information about the events of the future. According to Mooth information should be
considered like any other rare resource. Apart from this, rational financial agents while making their
expectations should make use of the knowledge related to economic system. Hence Hypothesis of
Ratex believes this that personal financial agents use complete available information in building
expectations and they prepare this information from their rational. This assumption is important that
Ratex does not express the consumer or firm to be far sighted or their expectations to be always correct.
It indicates that agents think over the previous errors and if necessary, to stop the reoccurrence of
such errors, review their expected behaviour. Objectively such assumptions indicate that agents are
successful in removing regular expected errors so that such errors are average unrelated to available
information.
Ratex hypothesis may be applied to economic (monetary, fiscal and income) policies. Those applying
rational expectations have shown ineffectiveness of stabilising policies. According to them, due to
change in economic policies (monetary, fiscal and income), no one has much information about
the effects of it on the economy. Specially, it means to put a stop on Macroeconomic policies as tax
cutting, increasing government expenditure, increasing money supply or making a deficit budget etc
for controlling economic recession. Their reasoning is that public has learnt this from the previous
experience that government will follow such policies. That is why government by adapting these
influences cannot befool the public and mere indication of such policy may create expectation of
countercyclical reaction from the government. In this way according to Ratex hypothesis people
make assumptions about fiscal and monetary policies of the government and while taking financial
decisions, pay attention towards them. As a result of it, by the time indications about governmental
policies are received, public had already worked upon them and their impact ends. In other words,
Ratex Hypothesis tells this that policy-moves bring changes in the financial behaviour of the people
which are not expected beforehand and they are unexpected moves from the government. Once when
people receive information about the policy and there is expectation of its getting started then it may
bring changes in the financial behaviour of the people.

Rational Expectations and the Phillips Curve

In the acceleration hypothesis of Phillips curve promoted by Friedman, short term trade-off between
unemployment and inflation but long-term trade-off is not there. It reason is that inflationary
expectations are based on previous tendency of inflation which cannot be forecasted exactly correct.
Because the expected rate of inflation is always behind its actual rate, which is why an observed
error is found. For adjusting the expected rate of inflation with its actual rate, by adding some ratio

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