Rational Expectations: Macroeconomics for the 1980s?

176 Pages·1984·12.128 MB·English

by  Michael Carter, Rodney Maddock (auth.)

Rational
Expectations
RATIONAL
EXPECTATIONS
Macroeconomics
for the 1980s?
Michael Carter
The Australian National University
and
Rodney Maddock
The Australian National University
M
MACMILLAN
© Michael Carter and Rodney Maddock 1984
All rights reserved. No part of this publication
may be reproduced or transmitted, in any form
or by any means, without permission
First published 1984 by
Higher and Further Education Division
MACMILLAN PUBLISHERS LTD
London and Basingstoke
Companies and representatives
throughout the world
British Library Cataloguing in Publication Data
Carter, Michael
Rational expectations
1. Macroeconomics
I. Title II. Maddock, Rodney
339 HB 172.5
ISBN 978-0-333-33144-6 ISBN 978-1-349-17644-1 (eBook)
DOI 10.1007/978-1-349-17644-1
To Jenny, Chris and Juan
Contents
Preface x1
1 Introduction 1
1.1 TheoryDevelopment 3
1.2 Theory and Society 6
1.3 Conclusion 10
2 Expectations in Economics 12
2.1 What are Expectations? 12
2.2 The Cobweb Model 14
2.3 Extrapolative Expectations 18
2.4 Adaptive Expectations 20
2.5 Rational Expectations 28
2.6 Conclusion 35
Appendix: Some Topics from Probability Theory 36
Random variables and expectations 36
Stochastic processes 39
3 Demand Policies to Reduce
Unemployment 43
3.1 The Tools of Macroeconomic Policy 44
3.2 Aggregate Demand and Supply 45
3.3 The Slope of the Aggregate Supply Curve 51
Workers are fooled 58
Money wages are inflexible 60
vii
viii Contents
3.4 The Natural Rate of Unemployment 68
3.5 Inflation and Expectations 69
3.6 EconomicTargetsandthePolicyRule 74
3.7 Conclusion 77
Appendix: The Phillips Curve 79
Rational Expectations: the Challenge to
4
Policy 89
4.1 The Model 90
4.2 Solving the Model 93
4.3 The Policy Rule 96
4.4 Would Adaptive Expectations make any
Difference? 100
4.5 Conclusion 101
5 The Counter-Attack 103
5.1 Rational Expectations are too Implausible 105
Individuals are rational 106
The honest government argument 110
All profit opportunities will be exploited 110
Only a subset need be rational 111
No competing theories 111
5.2 Learning to be Rational 111
5.3 The Economic Model is Wrong 114
Continuous market clearing 115
Non-treatment of capital 117
Persistence 118
6 Does the World Fit the Models? 121
6.1 DirectTests 123
Unbiasedness 123
Efficiency 125
Conclusion 126
6.2 The Output-Inflation Trade-off 127
6.3 Testing the Natural Rate Hypothesis 129
6.4 Testing the Combined Hypotheses 131
6.5 Response to Failure 133
6.6 Only Unanticipated Policy Matters 136
6.7 Conclusion 141
Contents ix
7 Looking Backward and Looking Forward 144
7.1 HowhasEconomicsChanged? 147
7.2 Have Rational Expectations Theorists Succeeded on
their Own Terms? 153
7.3 Conclusion 156
References 158
Author Index 162
Subject Index 164
Preface
Once again, macroeconomics is at the forefront of economic
debate. Theory and practice are pursued with a vigour not seen
since the Great Depression and the days of Keynes. If there is a
single focal point of the modern debate, then it is surely rational
expectations. The theory of rational expectations was presented to
the economics profession as a rationale for its own impotence. A
deceptively simple concept, its implications appeared at first to be
radical and profound. With the passage of time, a more secure
analysis of the impact of rationality is now emerging. The rational
expectations revolution has highlighted some of the shortcomings
of the orthodox Keynesian synthesis which guided economic policy
through the 1950s and 1960s. But has it provided a better
alternative theory to guide policy in the 1980s? Our book seeks to
answer this question.
It does not purport to be a comprehensive survey of all that has
been written on the subject of rational expectations. That task has
been undertaken by others. Nor, certainly, does it claim to be an
authoritative and ultimate assessment of an era in economic
thought. Our book has much more modest objectives. We have
aimed to set out the central ideas of rational expectations in a
macroeconomic context in a manner which we hope is accessible to
beginning students. We also hope that it will prove of value to
those non-professionals with some background in economics who
are mystified by the intellectual basis of current macroeconomic
xi
xii Preface
policy. Much of the literature on rational expectations is abstruse
in the extreme. Our task has been to present the essence of this
work in a simple and coherent fashion. Wherever necessary, we
have not hesitated to substitute clarity for rigour. We encourage
the reader who is curious about the finer points to consult the
original journal articles. Indeed, a subsidiary aim of this book is to
equip the motivated reader to tackle the journal literature.
There is a strong theme underlying our book - namely, that
economic research does not proceed serendipitously like the
drunk's random walk. Rather, the direction of economic research
responds to the state of the world. Rational expectations came
along when it did because of the demonstrated failure of pre
existing theory to explain the dismal economic performance of the
period. But economic researchers also tend to act like the drunk
who looks for his car key under the light of the lamp-post rather
than in the dark where he dropped it. They like to cling to familiar
territory, they are reluctant to abandon a line of research even if
there is mounting evidence that the key is not to be found there.
There is a tendency to focus on problems which are tractable
though less relevant. These characteristics of economic research
are evident in the story of rational expectations. Indeed, we
believe that the development of the theory becomes much clearer
if it is viewed from the perspective of an evolving research
programme. We have highlighted this methodological perspective
and organised our presentation in historical fashion. Methodolog
ists will recognise a strong Lakatosian (Lakatos, 1970) flavour.
This makes the development of rational expectations more trans
parent. In addition to its intrinsic interest, the story of rational
expectations is of interest as a case study in the development of
economic thought. We hope that the book might be useful
supplementary reading for courses in economic methodology or
the history of economic thought.
The book traces its heritage to a well-received article published
in the Journal of Economic Literature (Maddock and Carter,
1982). Readers of that article might wonder what has happened to
Bert and Ernie. We can assure you that they are alive and well and
have not given up arguing with one another about the world of
economics. However, we felt that they had reached their limit in
this particular topic. A more conventional presentation was better
suited to a book-length exposition. Naturally, the book covers a