Transcript The Theory of Capital Markets

Expectations and Macroeconomic
Stabilization Policies
Adaptive and Rational Expectations
Adaptive 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,
Pexp, 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
P
AS2 AS1
Rational expectations cause
offsetting changes in AS given
a change in AD.
P2
P1
0
2
P rises but Y remains constant.
1
Y1 Y*
AD2
AD1
Y
Anticipated Policy Changes
Y
Y
Y=F(L)
0
w/P
L 0
P
Y
SRAS2
SRAS1
LS 1
P3
P2
w1/P1
w1/P2
2
P1
3
2
1
AD2
AD1
LD
0
L1
L*
L 0
Y1 Y*
Y
Anticipated Monetary Policy
• Let the money supply increase, causing the
aggregate demand curve to shift to the right.
• The price level rises to P2, and the real wage falls
to w1/P2.
• 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 Y1 with an efficiency wage of
w2/P3 equal to w1/P1.
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.
Unanticipated Policy Changes
AS1
P
Only unanticipated policy
changes result in a change
in output.
2
P2
P1
0
1
Y1 Y2
AD2
AD1
Y
Unanticipated Policy Changes
Y
Y
Y=F(L)
LRAS
0
w/P
L 0
P
Y
SRAS
LS
w1/P1*
w1/P2
P2
P1
2
1
AD2
AD1
LD
0
L1 L2 L*
L 0
Y1 Y2 Y*
Y
Unanticipated Expansionary
Monetary Policy
• Let the money supply increase, causing the
aggregate demand curve to shift to the right.
• The price level rises to P2, and the real wage
falls to w1/P2.
• Labor demand rises to L2 while labor supply
responds with a lag.
• Unemployment falls below the natural rate.
• Output rises to Y2.
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.