Page 270 - DECO402_Macro Economics

Unit-30: Rational Expectations Hypothesis

of observed error in the first period, according to the experience in the first period its expected rate Notes
is reviewed.
Economists good at rational expectations have denied the possibility of trade-off between inflation and
unemployment during long period also. As per them, this concept hidden in his saying is unrealistic
that price expectations are primarily made on the basis of experience of previous inflation. When
people put their price expectations on this basis, then they are irrational. If they think so during
rising prices, they will find that they were wrong. But rational people will not make such mistake,
instead they will in comparison to future inflation, will use the entire available information for more
accurate prediction.
In relation to Phillips curve, thought of rational expectation has been presented in figure 30.1. Assume
that rate of unemployment is 3% and rate of inflation is 2%. We will start from point A on curve SPC .
2
For reducing unemployment government increases the rate of money supply, because of which prices
start rising. According to Ratex hypothesis, firms in comparison to general price level, have more
information about the prices of their industry. Their mere thinking this is a mistake that increase in
prices has happened due to increase in demand of their goods. As a result of it, for increasing production
they employ more workers, by which unemployment reduces. Workers also make the mistake of
considering the rise in prices to be related to their industry. But when demand for labourers increase,
wages increase and workers consider increase of monetary wages to be an increase of actual wages.
In this manner economy, on short term Phillips curve SPC moves upwards from point A to point B.
1
But soon firms find that in all industries there has been an increase in prices and wages. Firms also
find out that their costs have increased. With an increase of 4% in inflation rate workers feel that their
actual wages have reduced and they put pressure for increasing wages. In this manner, because of
monetary policy of the government, inflation rate increases in the economy. Consequently, on curve
SPC it moves from point B to point C where inflation rate is 3% which is equal to that before the
2
adoption of expansive monetary policy by the government.
When government again tries to reduce employment by
increasing money inflation then it cannot make a fool of
those workers and firms who will now keep an eye on
activities of costs and prices in the economy. If firms expect
increase in prices along with cost of their goods then they
will not try to increase their production as happened in
case of curve SPC . As far as workers are concerned, labour
1
organisations will demand for increasing wages according
to increasing prices. When government keeps monetary
expansion (or fiscal) policy on, workers and firms get used
to it. Their experience only becomes their expectations. Figure 30.1
Hence when government again adopts such policy then
firms increase their prices for making the expected inflation
ineffective so that it does have an influence on production and employment. In the same way, in
expectation for inflation workers demand for more wages and firms do not give much jobs. In other
words, firms and workers make their expectation in wages agreement and price policy so that in the
actual rate of unemployment and natural rate, even in short term also, there is no difference.

Task Express your thoughts on rational expectations.

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