RATIONAL EXPECTATIONS IN MACROECONOMICS

CHAPTER 1: EXPECTATIONS IN MACROECONOMICS

"The evidence relating to the [rational expectations] hypothesis is very mixed. The dominant
role assumed by rational expectations is more because of its theoretical appeal, and the
absence of an equally attractive alternative, than because of an overwhelming weight of
evidence in its favour"

1.1 THE IMPORTANCE OF EXPECTATIONS IN MACROECONOMICS

'Few, if any, of the important macroeconomic relationships such as the consumption

function or the demand for money are likely to be free from the influence of expected
variables,, such as expected income or expected interest rate.'

(a) Expectations and the Keynesian IS-LM model

Consider the elementary Keynesian view of the economy expressed in conventional IS-LM
terms:
IS curve is volatile: it is likely to shift by quite large amounts as firms change the amount of
investment expenditure that they wish to undertake
LM curve is not steep - it is even likely at times to be almost horizontal
Implies that sharp fluctuations in aggregate demand will occur whenever the IS curve shifts.
- Essential message of Keynes's General Theory (1936): sharp fluctuations in aggregate
demand can originate in the private sector, and because they are likely to lead to sharp,
undesirable fluctuations in the level of output and employment the government should vary
its own expenditures to offset them.
But why do Keynesians believe that the IS curve is volatile and the LM flat? {Expectations}
- The volatile IS curve arises in Keynes's view because firms' expectations about the future
profitability of their investment projects are themselves highly volatile (subject to "animal
spirits": 'a spontaneous urge to action rather than inaction and not as the outcome of a
weighted average of quantitative benefits multiplied by quantitative probabilities.')
- According to Keynes's view of the demand for money, the typical individual holds an
expectation of what the future interest rate is likely to be. If the actual rate is below its
expected value the individual expects it to rise and hence the price of bond to fall. There will,
for each individual, be some actual rate of interest so low that the expected losses from
holding bonds just outweigh the interest earned on them. At this 'critical rate of interest' the
individual's demand for money becomes extremely responsive to a change in the interest
rate. => On certain assumptions there will be some interest rate so low that the aggregate
demand for money will likewise become very responsive to interest rate changes. It is this
extreme responsiveness of the demand for money to changes in the rate of interest - the so-

called liquidity trap - which makes the LM curve horizontal and implies that sharp
fluctuations in aggregate demand will occur in response to movements of the IS curve.
Keynesians believe expectations about future interest rates to be very slow moving, in effect
treating the expected rate as constant for each individual, giving a horizontal LM curve,
THEREFORE expectations play a dual role in elementary Keynesian analysis: volatile
expectations about the profitability of future investment projects - IS curve - and nearconstant expectations about the future rate of interest - LM curve - are part of the
mechanism by which such shifts produce sharp movements in aggregate demand.

(b) Expectations and the consumption function

Permanent Income Hypothesis: the actual value of consumption expenditure in any period which is a key component of total spending in an economy - depends on an expected
variable, in this case expected or permanent income.
Friedman (1957): the permanent component if income is 'analogous to the "expected" value
of a probability distribution'

(c) Expectations and the natural rate hypothesis

Workers are interested not in the nominal value of their wage rate W but in its real value
W/P. However, they cannot know for certain what the prices of all goods will be when they
come to buy them. They will have to form an expectation about the general level of prices.
The method by which workers form their expectations of future prices therefore influences
the effect that changes in aggregate spending have on employment.

1.2 THE NEED FOR A THEORY OF EXPECTATIONS

There is little data available on expected values, more data on actual values. It would be very
costly to obtain even a single, continuous and accurate expectations series. Additionally,
beliefs about the future are not easily interpretable

The challenge posted by the shortage of data on expectations is that of devising a theory of
how expectations are formed which is general in its applicability, which can be tested, and
which allows us to estimate macroeconomic relationships which include apparently
unobservable expectations terms.

1.3 THE ADAPTIVE EXPECTATIONS HYPOTHESIS

Basic idea: a person will change his expectation of any variable by some fraction of the
difference between the variable's actual value last period and what he was expecting it to be
last period.
The hypothesis does not predict the exact amount by which you raise or lower your
expectation: that will differ from case to case and can only be determined empirically. If their
last period expectation turned out to be correct they will not change their expectation.

Attractive features:
i) While people can be fooled temporarily by the type of changes that we have assumed in the
inflation rate, they will not be fooled in the longer run. They make take time to adapt their
expectations fully, but they will catch on eventually.
ii) The hypothesis is apparently fairly general: works for unemployment, inflation, real
income growth etc.
iii) It allows us to relate expected, unobservable variables to actual, observable variables

Y t Y t 1 = (Y t1Y t 1)

Show recursively:

Y et = Y t 1+ ( 1 ) Y t2 + ( 1 )2 Y t3 + ( 1 )3 Y t 4 +
Recursive substitution shows that, under AE, the expectation of any variable can be written
purely as a function of the past values of the actual variable.
Implausibility: the hypothesis in effect assumes that agents ignore information which would
enable them to improve the accuracy of their expectations. Therefore it appears to assume
suboptimal behaviour on the parts of the agents forming expectations.

CHAPTER 2: THE THEORY OF RATIONAL EXPECTATIONS

Basic idea: many economic variables should be seen as being determined by processes. The
process determining a variable can be seen as limiting the potential values of that variable,
and in doing so it provides a basis for a rational expectation.

2.1 VARIABLES AS THE OUTCOME OF PROCESSES

If the process determining a variable can be identified, expectations about the variable will
be more accurately formed. The predictions of any variable will be improved as more

information relating to the process determining the variable is used in forming the
prediction.

2.2 PROCESSES AND RATIONAL FORECASTS

Hypothesis: sensible people will use all the available information relating to the process of
determining a variable when forming their forecast or expectation of that variable.
The hypothesis of rational expectations war originally applies to the problem of forecasting
the future price of a good which took time to produce- Muth (1961)
FORMAL EQUATIONS:

Et 1 Y t =E(Y t I t1)
2.1
Where

I t 1 is the set of information available at period t1 .

Stochastic process:

Y t = 0 + 1 Y t1 + 2 X t 1+ 3 Z t 1+ t

2.2

t is a random variable which may be positive or negative.

Et 1 Y t = 0+ 1 Y t1 + 2 X t 1+ 3 Z t 1+ E t1 t

2.3

Et 1 t =0

2.4

Y t Et1 Y t = t

2.5

It is not generally the case that the rational expectations hypothesis implies that forecasters
and expectations are always right. They will have zero expectational error for deterministic
processes but this error will be nonzero for stochastic processes. (Stochastic processes
include an inherently unpredictable element)

2.3 THE GENERAL CHARACTERISTICS OF RATIONAL EXPECTATIONS

If the process determining a variable Y is understood, the error of a rational expectation of Y

is the same as the random component of Y.
(a) The errors of rational expectations are on average zero
The best the rational forecaster could do is expect the mean or average value of
is 0.

, which

The size of the expectational error depends on the size of the unpredictable component of the
process itself. If the absolute value of

tends to be large, then so will the error of a

rational forecast, but that will be because Y is inherently difficult to predict, not because of
an unintelligent forecasting method.
(b) The errors of rational expectations exhibit no pattern
The theory of rational expectations rules out any pattern in forecasting errors and is more
precise about when the method of forming expectations will change. The random element
itself exhibits no pattern: it cannot be predicted on the basis of any information available at
the time the forecast is being made. If the error becomes determinable by a process, it would
be incorporated into the prediction.
(c) Rational expectations are the most accurate expectations
Rational expectations are the most efficient method of forecasting: with any other method of
forecasting the level of accuracy over any significant length of time can only be lower.

2.4 GENERAL CRITICISMS OF THE THEORY OF RATIONAL EXPECTATIONS

(a) The plausibility of rationality
Is it really plausible to assume that when forming expectations the typical individual is
sufficiently sensible to use all the information about the process determining a variable?
soln: expectations are rational on average.
Rationality implies that the individual weighs up the costs and benefits and carries out the
activity up to the point where the marginal cost is equal to the marginal benefit. When
applied to expectations formation this principle implies that forecasters should weigh up the
marginal costs of acquiring more information about the process determining a variable and
the information about the marginal benefits of making more accurate forecasts. But the point
at which the marginal benefits and the marginal costa are equal does not necessarily
correspond to the point at which the forecasting error is equal to the purely random
component of the determining process.
(b) The availability of information
Pretty self-explanatory forecasters may disagree about processes. But should slowly
converge as more information becomes available.
There are still reasons for believing that typical forecasts will exhibit two of the key features
of rational forecasts- an average error of zero and no pattern to the errors. For if they do not
it implies that forecasters are not fully exploiting the costless information provided by their
own errors.
(c) The limits to the applicability of rational expectations
The rational expectations hypothesis is seen as applying to variables which are determined
by recurring processes which are stochastic. But in many instances in economics the variable
about which expectations are being formed may not be of this type.
Many important economic events can be seen as genuinely unique, or at lease exceptional
and unusual.
(d) The testability of the rational expectations hypothesis

Expectations about a variable are almost always only part of a model. Tests of models which
incorporate the rational expectations hypothesis are therefore always joint tests of the
rational expectations hypothesis itself and the rest of the model. If the model fails the tests to
which it is subjected one can always rescue the rational expectations hypothesis by arguing
that it is the rest of the model which is wrong.
Observational equivalence: For any rational expectations model which fits the data there
will always be a non-rational expectations model which fits the data equally well. The data
themselves cannot discriminate between the two theories, which are said therefore to be
observationally equivalent.