The document outlines key concepts of rational expectations theory: 1) People form rational expectations and learn from past mistakes rather than simple adaptive expectations. 2) With rational expectations, monetary policy cannot stimulate the economy in the long run as prices and wages adjust to anticipated inflation. 3) Under rational expectations, there is no long-run trade-off between inflation and unemployment as both adjust to the natural rate.

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Rational Expectations Theory
23-01-2024

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Rational Expectations Theory- Some Basics
● The idea was originally proposed by John F Muth in 1961
● Became a very influential concept in the works of Robert Lucas, Sargent etc.
● This theory is the corner stone of recently developed macroeconomic theory,
popularly called as New Classical Macroeconomics
● Another version of natural rate of unemployment theory
● According to this, the economy is stable in the long run at its natural rate of
employment and the long run PC is a vertical line

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Short Case Study
Some of the largest economic fluctuations in the U.S. economy since 1970 have
originated in the oil fields of the Middle East. Crude oil is a key input into the production of
many goods and services, and much of the world’s oil comes from Saudi Arabia, Kuwait,
and other Middle Eastern countries. When some event (usually political in origin) reduces
the supply of crude oil flowing from this region, the price of oil rises around the world. U.S.
firms that produce gasoline, tires, and many other products experience rising costs, and
they find it less profitable to supply their output of goods and services at any given price
level. The result is a leftward shift in the aggregate-supply curve, which in turn leads to
stagflation.
Question:
1. What is the short and long run effect of reduction in the supply of crude oil in the global
market?

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Adaptive Expectations and Shift in PC
● Expectations about the future rate of inflation
● According to this people form expectations on the basis of previous and present rate
of inflation and change or adapt their expectations when the actual inflation turns out
to be different from their expected rate
● In Friedman’s theory as a result of expansionary monetary policy AD increases as a
result of which more output and higher price level happens- short run trade off
between inflation and unemployment
● In adaptive expectations theory nominal wages lag behind changes in the price level
which induce the firms to expand their output and employment

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Unemployment and Natural Rate Hypothesis
● According to Friedman, there is a certain rate of unemployment prevalent in
the long run irrespective of the rate of inflation
● The natural rate of unemployment theory, also known as the non-accelerating
inflation rate of unemployment (NAIRU) theory, was developed by economists
Milton Friedman and Edmund Phelps. According to NAIRU theory,
expansionary economic policies will create only temporary decreases in
unemployment as the economy will adjust to the natural rate. Moreover, when
unemployment is below the natural rate, inflation will accelerate. When
unemployment is above the natural rate, inflation will decelerate. When the
unemployment rate is equal to the natural rate, inflation is stable, or non-
accelerating.

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Rational Expectations
● According to this, there is no lag in the adjustment of nominal wages
● Nominal wages are quickly adjusted to any expected change in the price level
● There is no trade off between inflation and unemployment
● Rational Expectations Theory envisages that the rise in the price level is fully
and correctly anticipated by workers and business firms and get completely
and quickly incorporated into the wage agreements resulting in higher prices
of products
● It is the price level that is rising, leaving the real output and employment at the
level of natural rate of unemployment
● LAS is a vertical straight line at the potential GNP (natural rate of
unemployment)
● According to Rational Expectations Theory, given the resources and
technology, LPC corresponds to LAS curve and it is a vertical straight line at
the natural rate of unemployment

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Rational Expectations Theory
● Some economists, such as John F. Muth (‘Rational Expectations and the
Theory of Price Movements’ (1961)) and Robert Lucas, (Expectations and the
Neutrality of Money’ (1972)), challenge the view of adaptive expectations.
They argue that people can learn from past mistakes.
● As Lucas states in 1972 paper:
“The relationship, essentially a variant of the well-known Phillips curve, is derived
within a framework from which all forms of ‘money illusion’ are rigorously
excluded: all prices are market clearing, all agents behave optimally in light of
their objectives and expectations, and expectations are formed optimally.”

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Two Basic Elements
● Workers and producers being quite rational have a correct understanding of
the economy and therefore correctly anticipate the effects of government
policies. On the basis of these anticipations they take correct decisions to
promote their own interests
● Like the Classical economists, it assumes that all product and factor markets
are highly competitive. Thus wages and prices are highly flexible and
therefore can quickly change upward and downward. Thus the theory
assumes that new information is quickly and correctly assimilated

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Short run and long run PC
● Initially, at short-run Phillips Curve I (SRPC), inflation expectations are 2%
● However, if there is an increase in demand, then inflation increases to 3.5%
● Because inflation has increased to 3.5%, consumers adapt their inflation expectations and now expect
inflation of 3.5%.
● Therefore, with higher inflation expectations we now get a worse trade-off between inflation and
unemployment – shown by SRPC 2
● In the third year, if demand increases again, then initially people expect inflation of 3.5% – but when they
realise demand has pushed up inflation to 5% – then they revise their inflationary expectations upwards.

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Rational Expectations Theory- Key Takeaways
● The new classical macroeconomic model takes the theory of rational expectations into
account, essentially driving the short run to zero when economic actors successfully predict
policy implementation
● The new classical macroeconomic model draws the efficacy of expansionary monetary policy
(EMP) or expansionary fiscal policy (EFP) into serious doubt because if market participants
anticipate it, the AS curve will immediately shift left (workers will demand higher wages and
suppliers will demand higher prices in anticipation of inflation), keeping output at Y but moving
prices significantly higher
● Stabilization (limiting fluctuations in Y) is also difficult because policymakers cannot know with
certainty what the public’s expectations are at every given moment
● The good news is that the model suggests that inflation can be ended immediately without
putting the economy into recession (decreasing Y) if policymakers (central bankers and those
in charge of the government’s budget) can credibly commit to squelching it
● That is because workers and others will stop pushing the AS curve to the left as soon as they
believe that prices will stay the same as a result of appropriate government policies

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Examples of Rational Expectations
● High supply leads to low price. Therefore, farmers cut back on supply and
next year prices rise. Then the high prices lead to increased supply. Then
high supply leads to low price.
● When the Federal Reserve decided to use a quantitative easing program to
help the economy through the 2008 financial crisis, it unwittingly set
unattainable expectations for the country. The program reduced interest rates
for more than seven years. Thus, true to theory, people began to believe that
interest rates would remain low.