THEORY OF RATIONAL EXPECTATIONMishkin, Ch.7&28

EXPECTATION influence the behavior of all participants in the economy and have a major impact on economic activity

THE THEORY OF RATIONAL EXPECTATIONS

attempts to explain how economic agents form their expectations

EXPECTATION are important in every sector of the economy through their effects on policy and market behavior

1. Asset Demand and the determination of interest rateExpectations are central to the behavior of asset prices in a financial market (ch.5)Examples: expectation of inflation have a major impact on bonds prices and interest rate through the Fisher Effect

2. Risk an term structure of interest rateExpectations about the likelihood of bankruptcy are probably the most important factors in determining the risk structure of interest rate (Ch.6)

3. Foreign Exchange RateExpectation about the price level, inflation, tariff, and quotas, import and export demand, and the money supply play an important role in determining the exchange rate(ch.7)Expectation that a central bank is about to devalue and revalue its domestic currency are key feature of a speculative attack on a currency (Ch.19)

4. Asymmetric information and financial structureThe greater the expectations of the effects of adverse selection and moral hazard, the greater the effort of financial institutions to engage in activities to reduce asymmetric information problems and hence the greater the impact of asymmetric information on our financial structure

5. Financial InnovationExpectation about interest rate movements and the nature of the regulatory environment in the future effect the financial innovation

6. Bank Asset and Liability ManagementBank decision about which assets to hold are influenced by their expectations about the returns, risk, and liquidity of various assetsBank decision about which liabilities to assume are influenced by their expectations the cost taking on various liabilities

7. The Money Supply ProcessThe depositors and banks expectations have important role in the money supply process

8. Federal ReserveThe Feds expectations of inflation and the state of the economy affect the targets it sets for monetary policy

9. Demand for MoneyThe expectation about the return of holding money relative to other assets is an important factor determining the money demand

10. Aggregate Demand The expectations (animal spirits) is a major factor driving aggregate demand and the business cycle

11. Aggregate Supply and InflationWorkers expectations about inflation and the likely response of the government policy affect the positions of the AS curveThe publics expectations play a central role in cost-push inflation

ADAPTIVE EXPECTATIONS1950s and 1960s: expectations as formed from past experience only adaptive expectations, changes in expectations will occur slowly over time as past data changeExample: If inflation had formerly been steady at 5% rate expectations of future inflation would be 5% tooIf inflation rose to steady rate at of 10%, expectations of future inflation would rise toward 10%, but slowly

= Adaptive expectations of inflation at time t = Inflation at time t-j= A constant between the values of 0 and 1Adaptive expectation of Inflation

RATIONAL EXPECTATION:People use more information than just past data on a single variable to form their expectations of that variable

Their expectation of a variable will almost surely be effected by their prediction of future monetary policy as well as by current and past monetary policy

People often change their expectations quickly in the light of new information

John Muth developed a Theory of Rational Expectation

Theory of Rational Expectation:Expectation will be identical to Optimal Forecast (the best guess of the future) using all available information

Formal Statement of the theory of Rational ExpectationsXe = Xof

Xe : expectations of the variableXof: optimal forecast of X using all available information

Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate (?)

2 reasons why an expectations may fail to be rational:People might be aware of all available information but find it takes to much effort to make their expectation the best guess possiblePeople might be unaware of some available relevant information, so their best guess of future will not be accurate

Implication of the theoryIf there is a change in the way a variable moves, the way in which expectations of this variable are formed will changes as wellThe forecast errors of expectations will on average be zero and can not be predicted ahead of time

Rational Expectation: Implication for Policy1970s and 1980s, economist used ratexs theory to examine why activist policies appear to have performed so poorly?Does macroeconomic model can be used to evaluate the potential effect of policyDoes policy can be affective when public expects that it will be implemented?Rational expectation revolution

Lucas critique of policy evaluationPresented argument that had devastating implication for the usefulness of conventional econometric model for evaluating policyThese models could not be relied on to evaluate the potential impact of particular policy on the economyThe in which expectations are formed (the relation of expectations to past information) changes when the behavior of forecasted variables changes

The Lucas critiques point out not only that conventional economics models cannot be used for policy evaluation but also that the publics expectation about a policy will influence the response to that policy

1. New Classical Macroeconomic modelsDeveloped by Robert Lucas and Thomas SargentAll wages and prices are completely flexible with respect to expected changes in the price levelAnticipated policy has no effect on aggregate output; only unanticipated policy has an effect

Aggregat Output, YShort run response to unanticipated Expansionary Monetary Policy in the New Classical Model

Short run response to anticipated Expansionary Monetary Policy in the New Classical Model

Short run response to anticipated Expansionary Monetary Policy that Less expansionary than expected in the New Classical Model

Many economist who accept ratex as an working hypothesis do not accept the characterization of wage and price flexibility in the new classical modelThese critics of the classical model, object to complete wage and price flexibility and identify factors in the economy that prevent some wages and prices from rising fully with a rise in the expected price level 2. New Keynesian models

New Keynessian Model:Anticipated policy does have an effect on aggregate outputKeynesian model distinguishes the effects of anticipated versus unanticipated policy, with unanticipated policy having a greater effect

U Short run response to anticipated Expansionary Monetary Policy in the New Keynesian Model

Short run response to anticipated Expansionary Monetary Policy in the New Keynesian ModelYUAS1