Rational expectation hypothesis

From the late 1960s to the 1970s, a new phenomenon, known as

stagflation, appeared in the form of both high unemployment and
inflation.
This phenomenon of stagflation posed a serious challenge to
economists and policymakers because the Keynesian theory was silent
about it, so out of this crisis emerged a new macroeconomic theory
which is called the Rational Expectation Hypothesis (Raex)
 The idea of the rational expectation hypothesis was first put forth by
John Muth in 1961
His model dealt mainly with modelling price movements in markets.
By assuming that economic agents optimize and use information
efficiently when forming expectations,he was able to construct a
theory of expectations in which consumers’ and producers’ responses
to expected price changes depended on their responses to actual price
changes.
Muth’s notion of rational expectations related to micro economics.
It was in early 1970s that Robert Lucas,Thomas Sargent and Neil
Wallace applied the ideas to problems of macro economic theory.
Basic propositions of the Rational expectation
Hypothesis
• The Ratex hypothesis holds that economic agents form expectations of
the future values of economic variables like prices, incomes, etc. by
using all the economic information available to them.
• This information includes the relationships governing economic
variables, particularly monetary and fiscal policies of the government.
Thus the rational expectationists assume that economic agents have
full and accurate information about future economic events.
• According to Muth, information should be considered like any other
available resource which is scarce.
• Further, rational economic agents should use their knowledge of the
structure of the economic system in forming their expectations.
• Thus the Ratex hypothesis “presumes that individual economic agents
use all available and relevant information in forming expectations and
that they process this information in an intelligent fashion.
• It is important to recognise that this does not imply that consumers or
firms have “perfect foresight” or that their expectations are always
“correct”.
• This implies that agents reflect on past errors and modify their expected
behavior if necessary, thus eliminating the sequence in these errors. The
theory suggests that agents succeed in eliminating sequences that involve
expected errors, so that the errors are on average uncorrelated with the
available information.
• The Ratex hypothesis has been applied to economic (monetary, fiscal and
income) policies
• The rational expectationists have shown the short-run ineffectiveness of
stabilization policies
• According to ratex theory, people form expectations about the government's
monetary and fiscal policies and refer to them when making economic
decisions.
• In other words, the ratex theory claims that the only policy moves
that change people's economic behavior are unexpected and
surprising moves by the government.
• We discuss some of the policy changes in the light of the Ratex
hypothesis below.
• Rational Expectations and the Phillips Curve
• In the Friedman-Phelps acceleration hypothesis of the Phillips curve,
there is a short-run trade-off between unemployment and inflation
but no long-run trade-off exists
• Economists belonging to the rational expectations school have denied
the possibility of any trade-off between inflation and unemployment
even during the long run
• The rational people will use all available information to forecast
future inflation more accurately.
• The rational expectations idea is explained diagrammatically in Figure
1 in relation to the Phillips curve.
• Suppose the unemployment rate is 3 per cent in the economy and
the inflation rate is 2 per cent. We start at point A on the SPC1 curve.
• In order to reduce unemployment, the government increases the rate
of money supply so as to stimulate the economy. Prices start rising.
According to the Ratex hypothesis, firms have better information
about prices in their own industry than about the general level of
prices.
• They mistakenly think that the increase in prices is due to the increase
in the demand for their products. As a result, they employ more
workers in order to increase output. In this way, they reduce
unemployment. The workers also mistake the rise in prices as related
to their own industry. But wages rise as the demand for labour
increases and workers think that the increase in money wages is an
increase in real wages.
• Thus the economy moves upward on the short-run Phillips curve SPC,
from point A to B.
• But soon workers and firms find that the increase in prices and wages
is prevalent in most industries. Firms find that their costs have
increased. Workers realise that their real wages have fallen due to the
rise in the inflation rate to 4 per cent and they press for increase in
wages.
• Thus the economy finds itself at the higher inflation rate due to
government’s monetary policy. As a result, it moves from point B to
point C on the SPC2 curve where the unemployment rate is 3 per cent
which is the same before the government adopted an expansionary
monetary policy. When the government again tries to reduce
unemployment by again increasing the money supply, it cannot fool
workers and firms who will now watch the movements of prices and
costs in the economy. If firms expect higher costs with higher prices
for their products, they are not likely to increase their production, as
happened in the case of the SPC, curve.
• So far as workers are concerned, labour unions will demand higher
wages to keep pace with prices moving up in the economy. When the
government continues an expansionary monetary (or fiscal) policy,
firms and workers get accustomed to it.

• They build their experience into their expectations. So when the

government again adopts such a policy, firms raise prices of their
products to nullify the expected inflation so that there is no effect on
production and employment.
• Similarly, workers demand higher wages in expectation of inflation
and firms do not offer more jobs. In other words, firms and workers
build expectations into their price policies and wage agreements so
that there is no possibility for the actual rate of unemployment to
differ from the natural rate, N, even during the short run.
• Its Policy Implications:
• The Ratex hypothesis assumes that people have all the relevant information of the
economic variables. Any discrepancy between the actual rate of inflation and the
expected rate is only in the nature of a random error. When people act rationally, they
know that past increases in prices and the rate of change in prices have invariably been
accompanied by equal proportional changes in the quantity of money.

• When people act on this knowledge, it leads to the conclusion that there is no trade-off
between inflation and unemployment even in the short-run. It implies that monetary (or
fiscal) policy is unable to change the difference between the actual and natural rate of
unemployment. This means that the economy can only be to the left or right of point N
of the long-run Phillips curve IPC (in Figure 1) in a random manner. Thus the implication
is that stabilisation policy is ineffective and should be abandoned.
• Its Criticisms:
• The Ratex hypothesis has been criticised by economists on the following
grounds:
1. Unrealistic Assumption:
The assumption of rational expectations is unrealistic. The critics argue that
large firms may be able to forecast accurately, but a small firm or the average
worker will not be able to do so.
2. Costly Information:
It costs much to collect, distill and disseminate information. So the market for
information is not perfect. Therefore, the majority of economic agents cannot
act on the basis of rational expectations.
• 3. Different Information:
• The critics also point out that the information available to the government differs from that available to firms and
workers. Consequently, expectations of the latter about the expected rate of inflation need not necessarily be diverse
from the actual rate only by random error. But the government can accurately forecast about the difference between
the expected inflation rate and the actual rate on the basis of information available to it. Even if both individuals and
government have equal access to information, there is no guarantee that their expectations will be rational.

• 4. Prices and Wages not Flexible:

• Critics point out that prices and wages are not flexible. Economists like Philips, Taylor, and Fischer have shown that
monetary or fiscal policy becomes effective in the short run if wages and prices are rigid. The rigidity of wage rates
implies that they adjust to market forces relatively slowly because wage contracts are binding for two or three years at a
time.

• Similarly, the expected price level at the beginning of the period is expected to hold till the end of the period. Thus even
if expectations are rational, monetary or fiscal policy can influence production and unemployment in the short-run.
• 5. Expectations Adaptive:

• Gordon rejects the logic of the Ratex hypothesis entirely. He assigns two reasons for this:
first, individuals do not know enough about the structure of the economy to estimate the
market clearing price level and stick with adaptive expectations; and second, if individuals
gradually learn about the structure of economic system by a least-squares learning method,
rational expectations closely approximate to adaptive expectations.

• 6. Government not Impotent:

• It is generally said that according to the Ratex hypothesis, the government is impotent in
the economic sphere. But the Ratex economists do not claim this. Rather, they believe that
the government has a tremendous influence on economic policies.
• Stabilisation Policy and Ratex Hypothesis:
• According to the Ratex hypothesis, monetary and fiscal (stabilisation)
policies are ineffective even in the short-run because it is not possible
to anticipate accurately how expectations are formed during the
short-run. This is called “policy impotence.”