Question

The rational expectations hypothesis states that

  

A. people combine the effect of past policy changes on important economic variables with unpredictable views on what policy makers will do to determine what the economy will do in the future.

   

B. people understand how the economy operates and use their knowledge in making expectations about the future, but are uninformed about how fiscal and monetary policies are made and carried out.

   

C. people combine the effects of past policy changes on important economic variables with their own judgments about the future effects of current and future policy changes.

   

D. the government combines the effects of past policy changes on important economic variables with accepted views about the effects of current and future policy changes.

Answer 1

Option C is correct which states that people combine the effects of past policy changes on important economic variables with their own judgement about the future effects of current and future policy changes.

The idea of rational expectation was first discussed by John.F.Muth in 1961.He is the "father of rational expectation revolution in economics", primarily due to his article "Rational Expectation and the Theory of Price Movements".

Rational Expectations : An economic theory that states - When making decisions , Individual Agents will base their Decisions on the best information Available and Learn from the Past Trends.For example : Economy work, Government policy alters, Price levels, Level of Employment , Aggregate Output etc.

Before 1970 , there were two types of Expectation : I) Animal spirit and 2) Adaptive Expectations

Animal spirit means thinking hypothetically and the Animal spirit was supported by J.M.keynes who said that " The markets are moved by animal spirit , and not by reason ".

For example : If we change in fiscal monetary policy then we can work like Animal spirit or if Government starts taking taxes without any rhyme or reason.

2) Adaptive expectation: When we use past records to observe something or to see the changes in trends then it is called adaptive expectation.Like Philip curve was designed on the basis of data collected from last 10 or 15 years then some conclusion were drawn.

Adaptive expectation depend on past experience only. Expectation are a weighed average of past experience. And expectation change slowly over time.

Robert Lucas was responsible for using rational expectation theory to critique Keynesian notions of Government Spending.