Heterodox Rational expectations is an economic theory that seeks to infer the macroeconomic consequences of individuals' decisions based on all available knowledge.
It assumes that individuals' actions are based on the best available economic theory and information.
Robert Lucas and Thomas Sargent further developed the theory in the 1970s and 1980s which became seminal works on the topic and were widely used in microeconomics.
Significant Findings Muth’s work introduces the concept of rational expectations and discusses its implications for economic theory.
Muth’s paper also discusses the implication of rational expectations for economic theory.
For example, if individuals expect inflation to increase, they may anticipate that the central bank will raise interest rates to combat inflation, which could lead to higher borrowing costs and slower economic growth.
Similarly, if individuals expect a recession, they may reduce their spending and investment, which could lead to a self-fulfilling prophecy.
The paper argues that when individuals hold rational expectations, changes in the money supply do not have real effects on the economy and the neutrality of money holds.
Lucas presents a theoretical model that incorporates rational expectations into an analysis of the effects of changes in the money supply.
The model suggests that individuals adjust their expectations in response to changes in the money supply, which eliminates the effect on real variables such as output and employment.
He argues that a stable monetary policy that is consistent with individuals' rational expectations will be more effective in promoting economic stability than attempts to manipulate the money supply.
[3] In 1973, Thomas J Sargent published the article “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment” which was an important contribution to the development and application of the concept of rational expectations in economic theory and policy.
By assuming individuals are forward-looking and rational, Sargent argues that rational expectations can help explain fluctuations in key economic variables such as the real interest rate and the natural rate of employment.
He also suggests that the concept of the natural rate of unemployment can be used to help policymakers set macroeconomic policy.
This concept suggests that there is a trade-off between unemployment and inflation in the short run, but in the long run, the economy will return to the natural rate of unemployment, which is determined by structural factors such as the skills of the labour force and the efficiency of the labour market.
Sargent argues that policymakers should take this concept into account when setting macroeconomic policy, as policies that try to push unemployment below the natural rate will only lead to higher inflation in the long run.
Another important idea is that individuals adjust their expectations in response to new information.
They will learn from past trends and experiences to make their best guess of the future.
For example, suppose that P is the equilibrium price in a simple market, determined by supply and demand.
In other words, ex ante the price is anticipated to equal its rational expectation: where
If rational expectations are applied to the Phillips curve analysis, the distinction between long and short term will be completely negated, that is, there is no Phillips curve, and there is no substitute relationship between inflation rate and unemployment rate that can be utilized.
Mathematical derivation (1) Assuming that the actual process is known, the rate of inflation depends on previous monetary changes and changes in short-term variables such as X (for example, oil prices): (1)
Mathematical derivation (2) Even if the actual rate of inflation is dependent on current monetary changes, the public can make rational expectations as long as they know how monetary policy is being decided: (1)
Many economists suggested that it was an unrealistic and irrational assumption, as they believe that rational individuals will learn from past experiences and trends and adjust their predictions accordingly.
The rational expectations hypothesis has been used to support conclusions about economic policymaking.
An example is the policy ineffectiveness proposition developed by Thomas Sargent and Neil Wallace.
If the Federal Reserve attempts to lower unemployment through expansionary monetary policy, economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly.
If agents do not form rational expectations or if prices are not completely flexible, discretional and completely anticipated, economic policy actions can trigger real changes.
[5] While the rational expectations theory has been widely influential in macroeconomic analysis, it has also been subject to criticism: Unrealistic assumptions: The theory implies that individuals are in a fixed point, where their expectations about aggregate economic variables on average are correct.
[8] Lack of attention to distributional effects: Critics argue that the rational expectations theory focuses too much on aggregate outcomes and does not pay enough attention to the distributional effects of economic policies.