Rational Expectations School

Expectations on the future values of economic variables play an important role in macroeconomic analysis and economic analysis in general. Because of uncertainty about the future, individuals, business firms and governments form expectations on the future values of economic variables. To explain, firms invest in new plant and machinery only when it is expected to be profitable. Similarly consumers increase their spending when they experience increase in income. However, the extent of these changes depend largely upon whether the increase in income is expected to be permanent or temporary.

It has become an important topic since its introduction in the 1930s through the ex ante and ex post concepts applied to saving and investment functions. Expectations relate to theex anteconcept i.e. they refer to some assessment for future event or a set of events which, ex post, may turnout to be realized or not. The correctness and reliability of expectations is crucial to the notion of equilibrium. Because a state of economic affairs arrived at through decisions taken on the basis of expectations, which if turnout to be incorrect, cannot be considered as an equilibrium one. Earlier, expectations were incorporated into economic models mechanically. For instance, it was often assumed that the expected price level is a weighted average of past price levels, with latest price levels weighted more heavily. However, these formulations have been refuted because they may ignore information that may be relevant to the situation. This information may include several aspects like implementation of new fiscal and financial reforms, the possibility of drought conditions or sudden supply shocks like OPEC price hikes, etc. This inconsistency led to the formulation of new theories of expectations, such as Adaptive expectations, Rational expectations and Behavioral expectations. However, in this section, we concentrate on the theory of rational expectations.

By rational expectations, we mean those based on application of the principal of rational maximizing behavior to the acquisition and processing of information for the purpose of forming a view about the future. It is based on the efficient use of all available, relevant information. It suggests that individuals do not make systematic forecasting errors and that their guesses about the future are, on an average, correct. Thus, the theory suggests that individuals use all the available and relevant information when taking a view about the future and at a minimum use of information up to the point at which the marginal cost of acquiring and processing of information equals the marginal benefits derived from this activity. In the extreme case where information at hand is complete and there is no uncertainty this theory turns down to one of perfect foresights.

The hypothesis of rational expectations has three important implications for macroeconomic analysis and policy.

1. Econometric models are not very useful in evaluating alternative economic policies: Various econometric models have been used to obtain estimates of changes in the price level, output and employment as a result of government fiscal and monetary policies. These models are very helpful in assessing the impact of various policy alternatives. However, the advocates of rational expectations school contend that their usefulness is limited, because the parameters of the model will change when new policies are given prominence over the others. Since the estimates of the effects of the new policies are based on the original set of parameters, the actual implications may be quite different. As a result, econometric models are considered not so helpful in selecting an appropriate policy option.

2. No trade-off exists between inflation and unemployment: Following the statistical observation by A W Phillips that there was an inverse relationship between the ratio of change of money wage rates and unemployment rate, it was argued that lower unemployment could be obtained at the expense of higher inflation rates through more rapid increases in affective demand. However, some economists argued that a trade-off existed in the short run, but not in the long run. According to rational expectations, no trade-off exists even in the short run. Their argument is as follows. For example, if the central bank of a country implements a new monetary policy which streamlines credit to business sector and a more rapid increase in money supply. Since workers and business firms realize that the growth rate in money supply led to higher inflation, wages and prices (which are assumed to be flexible in rational expectations model) will adjust automatically. Assuming full employment in the economy, money wages and prices increase proportionately, leaving the real wage and unemployment unaffected. Thus, according to rational expectations, even though inflation has increased, the unemployment rate remains the same, implies no trade-off between money wage rate and unemployment rate.

3. Discretionary monetary and fiscal policy cannot be used to stabilize the economy: For example, that government spending increases say to Rs.100 crore in its purchases. Proponents of rational expectations maintains that consumers and business firms anticipate the implications of rise in government spending. Money wage rate and prices will rise, but output and employment will remain the same. The same sort of analysis is assumed to be applicable for other types of decisions in respect of both monetary and fiscal measures.

   However, the fact that output and employment fail to change in response to anticipated changes in fiscal and/or monetary policy does not mean that they are constant over time. If the changes are unexpected, output and employment will be altered. For example, the increase in government purchases mentioned earlier, if unanticipated, would result in higher levels of output and employment, as well as higher money wages and prices. Of course, as households and firms learn of changes in policy, output and employment will tend to return to their equilibrium levels. Output and employment will also change if the economy experiences shocks. By shocks, we mean unexpected changes in aggregate supply or demand. To illustrate, the huge increase in crude oil prices which occurred in 1973-74 was a supply shock. The decrease in aggregate supply of crude oil resulted in higher prices and had adverse impact on the world economy.

   As output and employment change in response to shocks, it is very tempting to argue that policy makers should use discretionary monetary and fiscal policy to offset the effects of these shocks. According to the rational expectations theory, however, discretionary policy will not be successful in stabilizing the economy. For example, if the economy experiences an unexpected reduction in aggregate demand, output and employment decreases. Assuming that policy makers have the same information as the public, expansionary monetary and fiscal policy serves no useful purpose, because money wages and prices will adjust so as to restore output and employment to their original levels even in the absence of such policies. Moreover, policy changes designed to offset shocks may generate errors in expectations, which will lead to greater fluctuations in output and employment. Thus, advocates of the rational expectations approach argue that monetary and fiscal policies should be designed so as to minimize uncertainty. For example, they favor increasing the money supply by monetary authority at a constant rate.