The Economics Book

246

market are rational, they do not
simply guess at future prices by
looking at previous ones. Instead,
they will attempt to forecast
future prices based on the
information available and—
critically—using a correct model
of the economy. They will make
educated predictions rather than
blindly following past behavior.
They will do this because if they
do not form their expectations
rationally, they will be punished
by the market and lose money.
We use rational expectations
all the time. Farmers, for instance,
make decisions about what to
plant based on past prices, current
conditions, and future probabilities.
They do not assume that if they
grow the same amount of the same
commodity they did five years
earlier, it will achieve the same
market price now—and neither do
the commodity dealers trading in
agricultural goods. Punishment
from the market forces people to
behave rationally and, over time,
their expectations can be assumed
to be as good as the best available
economic model. The theory of
rational expectations is deceptively

simple but has startling

consequences. Under adaptive

expectations government

intervention might work

temporarily because it could take

people by surprise. They would

not anticipate future government

policies and so an unexpected

expansion of spending would

act like a positive “shock” in

the economy, with short-term

real effects. Even these temporary

effects are impossible under the

theory of rational expectations

since people’s forecasts for price

increases adjust immediately.

Anticipating events

In 1975, two US economists,

Thomas Sargent and Neil Wallace,

claimed that if expectations are

rational, not only would individuals

begin to expect government

intervention, but they would

adjust their behavior in such

a way that policy would be

rendered ineffective. Assuming

rational expectations, people

would know that the government

had an incentive to generate

shocks, such as trying to keep

down unemployment. They

RATIONAL EXPECTATIONS

would adjust their expectations

accordingly. For example,

individuals would understand that

when a government attempts to

use monetary policy (such as

cutting interest rates) to maintain

employment, it leads to higher

inflation. People therefore alter

their expectations of wage and

price increases accordingly.

Instead of feeling wealthier, their

expectation of inflation cancels out

the effects of lower rates of interest

looked for by the government. In

this way monetary policy becomes

completely ineffective because

it will always be accounted for,

and people’s changed behavior

will undo it.

Policy makers had previously

believed that there was a trade-

off between unemployment and

inflation—that governments

could boost the economy and

achieve higher employment in

the long run with higher inflation

(pp.202–03). Under rational

expectations, this trade-off

dissolves. Unemployment is

determined by the productive

capacities of the economy: the

productivity and technological

capacities of its firms and

the efficiency of its markets.

Policy makers cannot boost

the economy beyond this level

of employment.

The Lucas critique

US economist Robert Lucas

pointed out that if individuals’

expectations do adjust with

policy, this means that the

whole structure of the economy—

the sets of relationships

between different households,

firms, and the government—

alters with changes in policy.

As a result the effects of

policy are not always those

that are intended.

It is rather surprising that

expectations have not

previously been regarded

as rational dynamic models,

since rationality is assumed

in all other aspects of

entrepreneurial behavior.

John Muth

A farmer in Australia inspects his
crop. Farmers do not decide what to
plant based solely on the past. They
also weigh factors such as the
weather and levels of demand.