Page 272 - DECO402_Macro Economics

Unit-30: Rational Expectations Hypothesis

have any influence on production. Similarly, predicting an increase in inflation workers demands Notes
for more wages and firms do not give employment to more workers. Hence it has no influence on
unemployment.
If seen in this way, Ratex hypothesis suggests this that expansive fiscal and monetary policies will have
a temporary impact in unemployment and if continued, may increase inflation and unemployment.
Success of such policies is only when people may not forecast them. Once when people forecast them
and mould themselves according to it then economy returns to its old natural rate of unemployment.
Hence for short term impact of fiscal and monetary policies on unemployment, government will
have to fool the public. But it does not happen always. If government continues these policies then
they become ineffective because it is difficult to befool people for a long time and they forecast its
effects on production and unemployment. In this way, fiscal-monetary policies become ineffective in
short term. According to those supporting Ratex hypothesis, inflation cannot be controlled without
doing extensive unemployment, if government declares monetary and fiscal policies and instead of
surprising people, explain them about it.

Criticisms
Economists have criticised Ratex hypothesis on the following basis:
1. Unrealistic Assumptions: Assumption of rational expectation is unrealistic. Critics reason
is that big firms may predict correctly but small firms and general workers will not be able
to do so.
2. Costly Information: Collecting information, its analysis and broadcasting is very expensive.
Hence there is no appropriate market for information. That is why most financial agents
cannot work on the basis of rational expectation.
3. Different Information: Critics also believe that information available to the government is
different from the information received by the firms and workers. Accordingly, expectation
of firms and workers regarding the possible rates of inflation may not necessarily be different
realistic rates just because of random error. But government on the basis of available
information may correctly predict the difference between the possible and expected rate of
inflation.
4. Prices and Wages not Flexible: Though reach of government and people to the information
is equal, still there is no guarantee that their expectations will be rational. Critics say that
prices and wages are not flexible. Economists like Phillips, Taylor and Fisher have shown this
that if prices and wages are stable then monetary and fiscal policies may be effective even
in short term. Meaning of stability of wage rates is they adjust with the market powers in a
comparatively slower form because wage contracts are applicable for two-three years at a
time. In the same way, from the beginning of the period possible price level is expected to be
maintained till the end of the time period. Hence if expectations are rational also, monetary
and fiscal policies may impact production and unemployment in short term.
5. Expectations Adaptive: Gordon has completely rejected the reason of Ratex hypothesis. He
has told two reasons- First, any person does not keep sufficient knowledge for predicting
the level of market adjusted prices and sticks to adaptive expectations. Second, even if any
how he learns about the structure of the economy still rational expectations will be very near
to adaptive expectations.
6. Government not Impotent: It is often said that according to Ratex Hypothesis, government
is incapable in economic field. But Ratex economists do not believe this, but their faith is that
government has a deep impact on economic policies.

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