Rational expectations theory

Whatever else you have learned about economic policy, you have certainly learned that economists don't all agree on what policies we should follow. Nevertheless, with certain notable exceptions, most economists today would more or less agree on two sets of policies. To fight inflation, you want to lower the rate of growth of the money supply and reduce federal government budget deficits. And to fight recessions, you want to do the opposite: increase the rate of growth of the money supply and increase the size of the deficits. Although some economists would only partially acquiesce for these policies, there has been a greater consensus for these stated policies than for any others.

You probably never saw Monty Python and the Holy Grail, but in that movie there was a group of knights who distinguished themselves solely by saying "Nee." No matter what questions they were asked, they would always answer "Neee." Assuming "Neee" was Middle English for nay or no, those knights were the rational expectations theorists, or the new classical economists of their day.

Like the "old" classical economists, today's rational expectationists say no to any form of government economic intervention. Such intervention, no matter how well intentioned, would do a lot more harm than good. In fact, they maintain that anti-inflationary and antirecessionary policies, at best, would have no effect whatsoever. More likely, say the new classical economists, these policies would end up making things worse.

Robert Lucas of the University of Chicago is clearly top gun among the new classical economists. Lucas believes that people can anticipate government policies to fight inflation and recession, given their knowledge of policy, past experience, and expectations about the future. Consequently, they act on this anticipation, effectively nullifying the intended effects of those policies. What, then, should the government do? It should follow strict guidelines rather than try to use discretionary policy to tinker with the economy.

Rational expectations theory is based on three assumptions: (1) that individuals and business firms learn through experience to anticipate the consequences of changes in monetary and fiscal policy; (2) that they act instantaneously to protect their economic interests; and (3) that all resource and product markets are purely competitive.

Now we'll translate. Imagine the Federal Reserve decides to increase the money supply's rate of growth sharply. Why would the Fed do this? To stimulate output and raise employment.

The scenario, according to the Fed, would be as follows: (I) the money supply rises; (2) business firms order more plant and equipment and more inventory; (3) more jobs are created and output rises; (4) wages do not rise right away, but prices do; (5) because prices rise and wages stay the same, profits rise; (6) eventually wages catch up to prices, profits go back down, and the expansion comes to an end.

This may have happened in the old days, say the rational expectations theorists, but surely people have learned something from all this experience. Everybody knows that when the Fed sharply increases the monetary growth rate, inflation will result. Business firms, of course, will raise prices. But what about labor? Anticipating the expected inflation, wage-earners will demand wage increases now. No more playing catch-up after the cost of living has already risen.

If wage rates are increased along with prices, do profits increase? No! If profits are not rising, there goes the main reason for increasing output and hiring more people— which, of course, was why the rate of monetary growth was raised in the first place.

Let's return to the rational expectations theorists' three assumptions. The first one is plausible enough - that through experience, we learn to anticipate the, consequences of changes in monetary and fiscal policy. So, if a sharp increase in the rate of growth of the money supply always leads to inflation, eventually we will all learn to recognize this pattern.

It would follow from the next two assumptions that the intended results of macroeconomic policy shifts will be completely frustrated. Why? If you knew that prices would be increasing, would you be willing to sit back and passively accept a decline in your standard of living? Wouldn't you demand a higher wage rate to keep pace with rising prices? The rational expectations theorists say people can always be expected to promote their personal economic interests, and furthermore, in a purely competitive market, they are free to do so.

In a purely competitive labor market, workers are free to leave one employer for another who offers higher wages. In a purely competitive products market, all firms are subject to the law of supply and demand, and will automatically pass along any wage increases in the form of higher prices.

Most macroeconomic policy changes, say the rational expectations theorists, are readily predictable. When there's inflation, there are extended debates in Congress, demands for cuts in government spending and tax increases, and a slowdown in the rate of monetary growth. Both Congress and the Federal Reserve generally telegraph policy moves, often months in advance. The point is that when these moves are made, no one is surprised. And because the public anticipates these policy changes, their intended effects are canceled out by the actions taken by individuals and business firms to protect their economic interests. In the case of policies aimed at raising output and employment, all the government gets for its efforts is more inflation.

What should the government do? It should do, say the rational expectations theorists, as little as possible. Like the classical economists, they believe the more the government tries to be an economic stabilizing force, the more it will destabilize the economy.

Basically, then, the federal government should figure out the right policies to follow and stick to them. What are the right policies? Funny you should ask? As you might expect, they've taken up the conservative economists' agenda: (1) steady monetary growth of 3 to 4 percent a year (the monetarists' monetary rule) and (2) a balanced budget (favored by the classical economists, among others).

Like every other school of economics, the rational expectations school has certainly received its share of criticism. In fact, only a small minority of economists today would consider themselves new classical economists, mainly because this group just goes too far in ascribing rationality to both the general population and themselves.

Is it reasonable to expect individuals and business firms to predict the consequences of macroeconomic policy changes correctly when economists themselves come up with widely varying predictions, most of which are wrong? Economists place little faith in each other's rationality; is it rational for them to ascribe a greater prescience to the general population than they give themselves?

In a world of constant change, is it possible for people to accurately predict the economic consequences of policy changes? Indeed, when a continually changing cast of policy makers, each with his or her own economic agenda, seems to be calling for entirely new economic approaches every few years, it's awfully hard to tell the players without a scorecard - it's even harder to predict the final score.

A second criticism of the rational expectations school is that our economic markets are not purely competitive; some are not competitive at all. Labor unions are not an economist's idea of purely competitive labor market institutions. Nor would industries such as those that produce automobiles, petroleum, cigarettes, and breakfast cereals, each of which has just a handful of firms doing most of the producing, be considered very competitive.

Finally, critics raise the question of the rigidities imposed by contracts. The labor union with the two - or three-year contract cannot reopen bargaining with employers when greater inflation is anticipated because of a suddenly expansionary monetary policy. Nor can business firms that have long-term contracts with customers decide to charge higher prices because they perceive more inflation in the future.

Should we summarily dismiss the rational expectations school because it is so vulnerable to criticism? Most economists would probably concede that this school is correct in calling their attention to how expectations may affect the outcome of macroeconomic policy changes. In recent years, then, economists have become more aware that to the degree policy changes are predictable, people will certainly act to protect their economic interests. Because they will succeed to some degree, they will partially counteract the effect of the government's macroeconomic policy.

In other words, rational expectations theory has a certain validity, as do each of the other theories we discussed. The question we're left with is, “How valid is each theory relative to each of the others?”

18.2. Find in the text the English equivalents of these words and word-combinations:

1. виняток

2. неохоче згоджуватися

3. згода

4. відрізнятися

5. лицар

6. доброзичливий

7. шкода

8. передбачити

9. анулювати

10. директива

11. представлений на розгляд

12. халтурити

13. припущення

14. підняти, догнати

15. імовірний, правдоподібний

16. розстроювати плани, зривати

17. іти в ногу з чимось

18. сприяти

19. очікувати, передбачати

20. збалансувати, урівноважити

21. розуміти, прорахувати

22. притримуватися, приступити до виконання

23. черга денна

24. напророчити

25. наслідки

18.3. Read the text more carefully and in each paragraph find the sentences supporting the main idea of the text. What paragraph(s) contain(s) the most important information?

18.4. Give the summary of the text.

19.1 Read text 23 and be ready to distinguish between government purchases and transfer payments.

TEXT 23