Chapter 27
Rational
Expectations:
Theory And
Policy
Implications
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Learning Objectives
• Differentiate between rational and adaptive
expectations
• Explain why monetary policy is ineffective
under rational expectations
• Realize the importance of central bank
credibility under rational expectations
• Define monetary policy’s influence on interest
rates under different expectations regimes
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Introduction
• Expectations in the economy play a significant
role in the outcome of monetary policy
– Inflationary expectations enter into wage agreements
and, therefore, determine the shape of the aggregate
supply curve and the Phillips curve trade-off
– Expectations of monetary policy affect the timing of
interest rate responses to changes in the money
supply
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Introduction (Cont.)
• The models developed in earlier chapters
assumed that expectations of the future are
based on the past
• However, this assumption ignores other pieces
of information that might be important to a more
accurate estimate of future
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When are Expectations Rational?
• Adaptive expectations
– Assumes that inflation in the future is an
extrapolation of recent price trends
– Thus, if inflation has been on the increase, this
suggests that people expect inflation to continue to
go up
– This ignores any possible countercyclical policy
response by the Federal Reserve
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When are Expectations Rational?
(Cont.)
• Rational expectations
– People will use all available information to
formulate expectations of economic variables—
inflation, interest, money supply
– Individuals have strong incentives to make rational
forecasts and will act accordingly
– If their expectations are consistently wrong, they will
re-formulate the expectations model to include other
variables
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When are Expectations Rational?
(Cont.)
• Rational expectations (Cont.)
– Therefore, increasing inflation would lead to a
rational conclusion that the Federal Reserve will
engage in restrictive monetary policy to reduce
inflationary pressure
– Such expectations would be considered rational
because they include information that is relevant
for properly forecasting inflation
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Anticipated Versus Unanticipated
Monetary Policy
• Rational expectations combined with flexible prices
and wages concludes that anticipated monetary policy
will not impact economic activity
• Keynesian upward sloping aggregate supply curve
– Wages rise more slowly than prices since inflationary
expectations lag behind actual inflation
– Increasing money supply leads to higher output and less
unemployment as firms increase output
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Anticipated Versus Unanticipated
Monetary Policy (Cont.)
• Monetarists vertical aggregate supply curve
– With an anticipated increase in money supply,
subsequent inflation will also be anticipated
– With full flexibility of wages and prices, workers
insure wages move up simultaneously with prices
– Under those circumstances, there will not be any
increase in output or reduction in unemployment as a
result of anticipated growth of money stock
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Anticipated Versus Unanticipated
Monetary Policy (Cont.)
• Assume money growth is not anticipated
– Increased aggregate demand leads to higher prices
that are not anticipated
– Wages will lag prices and business firms hire more
workers to expand output
– Result is higher output and lower unemployment
when money supply growth is not anticipated
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Anticipated Versus Unanticipated
Monetary Policy (Cont.)
• Figure 27.1
– Two upward sloping aggregate demand curves whose
location depends on expected price level
– The initial equilibrium point is P1 and YE, consistent
with D1 and S( P1e)
– An increase in the money supply shifts the aggregate
demand curve from D1 to D2
– The output of the economy will be pushed beyond YE,
with lower unemployment, as long as the inflationary
impact is not fully anticipated
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FIGURE 27.1 Anticipated monetary policy
shifts aggregate supply along with aggregate
demand, leaving GDP unchanged.
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Anticipated Versus Unanticipated
Monetary Policy (Cont.)
• Figure 27.1 (Cont.)
– Once change in money supply is fully anticipated, the
e
P
aggregate supply curve will shift to S( 2 )
– Under the assumption of rational expectations, the price
level will increase to P2, and the economy will again be
operating at full employment, YE
– Thus the end result of an anticipated change in the
money supply is an unchanged level of economic
activity with a higher price level
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Implications for Stabilization Policy
• Stabilization policy usually falls under the category of
anticipated policy
• Therefore, it is generally correctly anticipated through
rational expectations
• Systematic policies are useless
• Because of rational expectations, only “erroneous”
(completely unanticipated) changes in the money
supply influence the level of economic activity
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Implications for Stabilization Policy
(Cont.)
• This suggests that the debate between rules
versus discretion is irrelevant, neither policy
employed by the Federal Reserve can influence
real economic activity
• The outcome of the rational expectations world
is decidedly classical-Monetarist rather than
Keynesian
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Implications for Stabilization Policy
(Cont.)
• Rational expectations is the main component of new
classical macroeconomics
• However, sluggish adjustments in the labor market are
part of the implicit and explicit contractual agreements
in the labor market
• In this case, wages may lag behind prices even if
expectations of inflation are formed rationally and the
result is the Phillips curve trade-off between
employment and inflation
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Inflation, The Phillips Curve,
and Credibility
• With an upward sloping aggregate supply curve,
policymakers could increase level of economic activity
and reduce unemployment as long as they were ready to
tolerate an increase in inflation
• Monetarists argue that in the short-run this might be so,
but after expectations have adjusted, the aggregate
supply curve is vertical with no permanent trade-off
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Inflation, The Phillips Curve,
and Credibility (Cont.)
• Rational expectations theory pushes the monetarists’
long-run analysis into short run by transforming a series
of upward-sloping aggregate supply curves into a
vertical one
• This condition, which is shown in Figure 27.2,
demonstrates that simultaneously shifting the aggregate
supply and demand curves, economy remains at
“natural” full employment level, YFE, at increasingly
higher prices
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FIGURE 27.2 Anticipated monetary
policy can affect only the price level.
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Inflation, The Phillips Curve,
and Credibility (Cont.)
• Keynesians argue that wage and price rigidity in the
economy prevent the aggregate curves from responding
as quickly as rational expectations would suggest
• The rational expectations adjustment model presents a
possibility that reducing inflation is accomplished
painlessly
– Small increase in unemployment and little lost output as
Federal Reserve reduces money supply
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Inflation, The Phillips Curve,
and Credibility (Cont.)
• Painless reduction of inflation (Cont.)
– As long as the Federal Reserve’s policy is credible,
the leftward shifts in the aggregate demand schedule
produced by a reduction in the money supply are
matched by equal leftward shifts in the aggregate
supply curve
– Result is a decrease in prices with the economy
remaining at the full employment level, YFE
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Inflation, The Phillips Curve,
and Credibility (Cont.)
• Above scenario of reducing inflation depends on
the credibility of the Federal Reserve
– If public suspects Fed will not stay the course
because of concern for increased unemployment,
might conclude Fed will reverse their policy
– The result is that the expected price level will not
fall, the aggregate supply curve will not shift
leftward, resulting in a reduction in output and
increased unemployment
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Interest Rates and Anticipated
Monetary Policy
• The rational expectations message for interest
rates is not much brighter than for
countercyclical policy in general
• The Monetarists acknowledge an increase in the
money supply might temporarily reduce interest
(liquidity effect), however, inflationary
expectations will ultimately drive nominal rates
above real rates
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Interest Rates and Anticipated
Monetary Policy (Cont.)
• With rational expectations, an anticipated
increase in the money supply immediately leads
to higher nominal interest rates
• The only way that monetary policy can reduce
interest rates in the short-run is to have a
completely unexpected expansion in the money
supply
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Interest Rates and Anticipated
Monetary Policy (Cont.)
• Since prices in financial markets are not set
by contractual agreement and respond very
quickly to changes in supply and demand,
rational expectations is a more relevant
theory than in explaining labor markets
adjustments
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