Question

What rationale does rational expectations theory provide for the ineffectiveness of discretionary policies?

Answer 1

The theory of rational expectation posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences. This theory suggests that people's current expectations of the economy are, themselves, able to influence what the future state of the economy will become. The ineffectiveness behind discretionary policies in rational expectation is because of the following reasons:

Policy Lags - Policy doesn't take into effect instantaneously. In the real world, it can take significant time for policy to play out.

Policy Imprecision - Discretionary policies don't always work out as planned because the tools are of varying precision.

Temporary and permanent Fiscal Policy - A complication to policy effectiveness is whether the policy is explicitly temporary or permanent.

Structural Economic Change takes time - Whenever an economy recovers from a recession, it doesn't usually revert back to its exact earlier shape. The internal structure of the economy evolves and changes and this process can take time.

The limitations of policy - Discretionary policies can help an economy that is producing below its potential GDP to expand aggregate demand so that it produces closer to potential GDP, thus lower the unemployment.