Expectations and Macroeconomic Stabilization Policies Adaptive and Rational Expectations

Adaptive Expectations –Expectations depend on past experience only. Expectations are a weighted average of past experiences. Expectations change slowly over time.

Rational Expectations The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information. –It is reasonable to assume that people act rationally because it is is costly not to have the best forecast of the future.

Rational Expectations Rational expectations mean that expectations will be identical to optimal forecasts (the best guess of the future) using all available information, but….. –It should be noted that even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.

“Irrational” Expectations? There are two reasons why an expectation may fail to be rational: –People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible. –People might be unaware of some available relevant information so their best guess of the future will not be accurate.

Rational Expectations: Implications If there is a change in the way a variable moves, there will be a change in the way expectations of this variable are formed. Therefore, the forecast errors of expectations will on average be zero and cannot be predicted ahead of time.

Policy Ineffectiveness Proposition According to the rational expectations hypothesis, macroeconomic policy actions that individuals and firms anticipate have no effects on real variables such as output and employment. Only unanticipated policy actions that people cannot predict in advance can influence real GDP and employment.

Rational Expectations Hypothesis Let people’s expectation of the price level, P exp, depend in part on their expectation of how the government will change the money supply, government spending, and taxes. Also assume that people can anticipate government policy with a great deal of accuracy.

Rational Expectations Hypothesis Expansionary monetary policy actions cause an increase in aggregate demand. If people correctly forecast those policy actions, then they fully anticipate the change in the price level that the actions will induce. As price expectations change, people’s wage demands change, causing an offsetting change in aggregate supply.

Rational Expectations Hypothesis AD 2 AD 1 AS 1 AS 2 Y 1 Y P P2P2 P1P1 Rational expectations cause offsetting changes in AS given a change in AD. P rises but Y remains constant. Anticipated Policy Changes Y*

Y L Y Y Y P L w/P Y=F(L) LS1LS1 w 1 /P LDLD Y 1 Y* SRAS 1 P1P1 AD 1 L 1 L* AD 2 w 1 /P SRAS 2 3 P3P3 P2P2 2

Anticipated Monetary Policy Let the money supply increase, causing the aggregate demand curve to shift to the right. The price level rises to P 2, and the real wage falls to w 1 /P 2. Labor demand rises,, but labor supply is not available at the lower real wage. Firms offer higher nominal wages, causing the short-run aggregate supply curve to shift left. Output remains at Y 1 with an efficiency wage of w 2 /P 3 equal to w 1 /P 1.

Unanticipated Policy Changes If people do not correctly forecast the government’s policy actions, then they do not correctly forecast the change in the price level induced by the policy change. In this case, as the price level rises output increases along the aggregate supply curve.

AD 2 AD 1 AS 1 Y 1 Y 2 Y P P1P1 Unanticipated Policy Changes P2P2 Only unanticipated policy changes result in a change in output Unanticipated Policy Changes

Y L Y Y Y P L w/P Y=F(L) LSLS w 1 /P 1 * LDLD Y 1 Y 2 Y* SRAS P1P1 AD 1 LRAS L 1 L 2 L* AD 2 P2P2 w 1 /P 2 2 1

Unanticipated Expansionary Monetary Policy Let the money supply increase, causing the aggregate demand curve to shift to the right. The price level rises to P 2, and the real wage falls to w 1 /P 2. Labor demand rises to L 2 while labor supply responds with a lag. Unemployment falls below the natural rate. Output rises to Y 2.

Rational Expectations: Conclusions The development of rational expectations ignited a major controversy among economists because the model yielded an implication of policy ineffectiveness that directly challenged the mainstream view that active fiscal and monetary policies are needed to moderate the inherent instability of a market economy.

Rational Expectations: Conclusions The research on expectations that followed the introduction of rational expectations increasingly supported the rapid expectations adjustment implied by rational expectations over the sluggish adjustment of adaptive expectations. This suggested that misperceptions would disappear so quickly that there was no time for countercyclical policies to be implemented.

Rational Expectations: Conclusions Ultimately, a consensus was reached that the key issue is not how expectations are formed, but whether changing expectations are really the only important source of output fluctuations. A series of statistical studies showed that the rational expectations model of the business cycle could not account for the observed slower responses of real world economies.

Conclusions Early rational expectations models seemed to suggest that active fiscal and monetary policies were not effective. Further research, however, demonstrated that the rational expectation models could not explain the slow response of real world economies. New approaches rely on underlying sources of friction in the market clearing process to explain business cycles.