Question

In the novel how the markets fail by John Cassidy, 1. According to rational expectations, anticipated government intervention will not have any impact on the economy. Why? What does the empirical data say about this idea?

Answer 1

Before analysing as why according to the theory of rational expectations, anticipated Government intervention won't have any impact on the economy we must learn about the theory of rational expectations.

John Muth is called the father of the rational expectations revolution. He developed rational expectations theory as a challenge to some of the ideas regarding aggregate demand from classic economist John Maynard Keynes. According to this theory people make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in the economy are equivalent to what people think the future state of the economy will become. Thus this contrasts with the idea that government policy influences people's decisions. Let us explain it with the help of an example, let us suppose that a farmer is taking decision about how much corn to be planted this year. According to this theory in doing so, the farmer will take into account his rational expectations. The farmer will decide how much corn to be planted this year based on two considerations, firstly his past expriences, which is what the price of corn was before, and secondly, they make decisions based on all the information they have, such as the current price of corn. These two things form the basis of his expectations of the future, or what he think the price of corn will be in the future. Farmers like him are making the same decision across the whole economy. So when we take aggregate of all the decisions in the economy we arrive at the aggregate supply of corn in the economy.This aggregate supply affects the actual price of corn at harvest time, which tends to be pretty close to what all the farmers together predicted. In addition, all their profit from planting and harvesting corn ends up being pretty much what all the farmers expected it to be, assuming no major changes in price from one year to the next. So, now we see how the farmers' rational expectations about the value of their corn basically held true.

This theory also applies to the labour market, specially what happens to unemployment. The workers and companies also make make decisions based on their rational expectations, ie, on the basis of their past expriences and all the information they have.So the labor market will generally be in equilibrium most of the time, so unemployment is at its natural rate. Thus the rational expectations theory concludes that since unemployment is basically at equilibrium, any attempt to alter it by Government will basically disrupt the price level in the economy. So the Government should not interfere. Thus this theory is completely in contrast with Keynessian view of Government intervention.

Although the discussion on rational expectations has invited divergent views there is an appealing acceptance of the theory from a broad range of economists largely because of its theoretical appeal and perhaps due to lack of better alternative. Much of the existing evidence significantly implies that the majority of the agents form adaptive expectations, but there is equally enough evidence in support of rational expectation hypothesis. For example evidence of forecast of financial markets prices is often considered to be a reflection of the market absorption of all the information available hence making capital market more efficient than other markets. Other markets are still not so perfect and therefore markets do not clear. There is a little disagreement among modern economists that people do indeed attempt to anticipate inflation. Keynesians maintain that reactions to a policy change will be slow and indecisive and their behavior is entirely rational. They also believe in wage rigidity on account of many institutional factors. Wages and prices are set in a long-term contract and cannot be renegotiated frequently. Because of these rigidities, Keynesians argue that discretionary monetary and fiscal policy should be used to stabilize the economy. Whereas in New Classical macroeconomic model, price surprises affect real output because people confuse nominal wage and price changes with real wage and relative price changes. Keynesians believe that people have information on general price movements and the price surprise may not last long.