Question

a. Specifically address the different policy recommendations specifically between the Keynesian and Monetarist/classical school for getting the economy out of the recession.

b. What about the rational expectations schooladjustment process?  What are some of the key assumptions of the rational expectations with regards to the business cycle and the flexibility of prices and wages?

Answer 1

a) The essential element of Keynesian economics is the idea the macroeconomy can be in disequilibrium (recession) for a considerable time. To help recover from a recession, Keynesian economics advocates higher government spending (financed by government borrowing) to kickstart an economy in a slump.

Classical economists believe that the economy is self-correcting, which means that when a recession occurs, it needs no help from anyone. Classical economicsts assumes the long run aggregate supply curve is inelastic; therefore any deviation from full employment will only be temporary. Whereas, Keynesians argue that the economy can be below full capacity for a considerable time due to imperfect markets.

Their view also differ in terms of goverment borrowing during recession, in the case of keynesian, it is suggested that goverment should borrow more to offset the fall in priavte spending. Whereas in the classical case it is suggested to run a balanced budget.

b)  The rational expectations theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences. It suggests that people’s current expectations of the economy are, themselves, able to influence what the future state of the economy will become. This precept contrasts with the idea that government policy influences financial and economic decisions.

The theory states the following assumptions:

• With rational expectations, people always learn from past mistakes.
• Forecasts are unbiased, and people use all the available information and economic theories to make decisions.
• People understand how the economy works and how government policies alter macroeconomic variables such as price level, level of unemployment, and aggregate output.

The rational expectations approach is often used to test the accuracy of inflation forecasts. For example, P^e_t is an individual’s forecast in year t-1 of the price level in year t. The actual price level is denoted by P_t. The difference between the actual price level and individual’s forecast is the forecast error for year t.

P_t – P^e_t = r_t is the individual’s forecast error in year t. With rational expectations, the forecast errors are due to unpredictable numbers. However, if people systematically under-predict or over-predict numbers, the price level expectations are not rational.

Under rational expectations, what happens today depends on the expectations of what will happen in the future. But what happens in the future also depends on what happens today. Many macroeconomic principles today are created with the assumption of rational expectations.