Limitations of rational expectations school, Macroeconomics

Limitations of the theory of rational expectations:

  1. Critics of this theory note that if policy makers have more information about the economy or their own actions than does the general public, policies can be devised that will alter output and employment. To illustrate, suppose clandestinely, the monetary authority increases the growth rate of the money supply. Since the more rapid increase in the money supply is unanticipated, output and employment increases. Of course, if the rational expectations view is correct, output and employment will return to their original levels after the public learns of the new policy. Consequently, the policy is effective only during the learning process, which may be short-lived. In the case where policy makers possess more information about the economy, it might be easier for them to disseminate the information and let the public act on it rather than going for new policy options.

  2. A second limitation of the theory of rational expectations has to do with the assumption of wage and price flexibility. Under the theory, money wages and prices are assumed flexible. But due to various reasons, they may be "sticky." As a consequence, even if expectations are formed rationally, money wages and prices may adjust slowly, resulting in changes in output and employment. Suppose, for example, that aggregate demand decreases. Assuming that households and firms anticipate the change, money wages and prices should fall so as to leave output and employment unchanged. But if money wages and prices are sticky, output and employment decrease, contrary to the theory of rational expectations. Critics of the theory claim that money wages and prices adjust only slowly over time. Thus, they believe that discretionary policy can alter output and employment, at least in the short run. Proponents of the theory respond by arguing that the role of policy would be limited in this context, since repeated use of policy will lead to changes in the types of contracts that are negotiated. The effects of these changes will reduce or eliminate the ability of policy makers to alter the equilibrium levels of output and employment through the use of a systematic policy.

  3. Opponents of this theory charge that the rational expectations theory cannot explain the prolonged periods of unemployment that we sometimes experience, especially in advanced industrialized economies. If expectations are formed rationally and if wages and prices are flexible, they claim that deviations from the equilibrium levels of output and employment should be short-lived. Since this implication appears to be inconsistent with actual experience, many critics reject the theory on this basis. In response, proponents have constructed theories of the business cycle based on rational expectations. These theories are capable of explaining the observed movements in output and employment.   

As we have discussed above, the theory of rational expectations is controversial. In fact, there is currently no universally accepted theory about expectations. At present only a small minority of economists appear to support the theory of rational expectations. On the other hand, support seems to be growing. Because of the theory's implications for the conduct of policy, resolution of the controversy is very important. The theory of rational expectations together with efficient market clearing led to the emergence of supply-side economics.

Posted Date: 9/18/2012 7:09:19 AM | Location : United States

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