Page 271 - DECO402_Macro Economics

Macroeconomic Theory

Notes Self Assessment
Multiple Choice Questions:
3. Before discussing about the Ratex hypothesis, it is __________ to understand the meaning
of adaptive expectations used in macroeconomics.
(a) important (b) unimportant
(c) sufficient (d) none of these
4. In the decade of 1930, when Keynes wrote his “General Theory”, then the main problem of
the world was _______.
(a) employment (b) unemployment
(c) labour (d) capital
5. During the Second World War, inflation emerged in __________.
(a) form of the main economic problem (b) form of war
(c) form of peace (d) none of these
6. Forecasts, along with the tendencies of the past, are based on current information and
________.
(a) news (b) experience
(c) theory (d) rules

30.4 Stabilisation Policy and Ratex Hypothesis
According to Ratex hypothesis monetary and fiscal (stabilization) policies are ineffective in short term,
because correctly guessing the expectation in short term is not possible. It is called policy impotence.
Ratex hypothesis is bases on this assumption that industries and firms keep correct information about
forthcoming economic activities. That is why their expectations are rational because they are based
on all available information, especially government activities. If government follows any favourable
monetary or fiscal policy then people know about it and according to it only they adjust their plans.
Hence whenever government adopts any possible policy then it is not effective because people by
predicting it had already adjusted their policies according to it. It means that government policy is
ineffective. Another important assumption is that all markets are completely competitive and wages
are completely flexible.
Come; first let’s take fiscal policy only. Those followers of theory of Keynes, advocate for an active
fiscal policy for reducing unemployment. But according to Ratex hypothesis cut in tax and/or increase
in government expense will reduce unemployment only if its short term effects on the economy are
unexpected for the people In other words, a fiscal policy may have a short term effect for reducing
unemployment, if people do not have a pre-assumption that prices will increase. But whenever
government sticks to such policy, then people have the hope for increase in inflation rate. Hence in
inflation workers seeing the possibility of heavy increase will demand for more wages and firms
predicting a rise in future costs will increase the prices of their goods. As a result of it fiscal policy
will be ineffective in short term. Through it, in long term, unemployment and inflation may increase,
when government tries to control inflation.
Similarly if government for reducing unemployment, increases money supply through an expansive
monetary policy, then it will also be ineffective in short term. Such policy may reduce unemployment
in short term only if its influence on the economy is not predicted. But when government sticks to
such expansive monetary policy then people have an expectation of increase in inflation rate. Firms
increase prices of their goods by which possible inflation may be made inactive so that it does not

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