The Economics Book

247

Traders in financial markets form

rational expectations based partly

on the actions of their colleagues at

work. Failure to read the signs will

lead to punishment by the market.

This became known as the “Lucas
critique,” and it was powerful
enough to convince most
economists that attempts to model
the whole economy through its
structural relationships, as
Keynesian models do, are flawed.
Modeling should instead focus
on people’s deeper underlying
preferences, and the resources
and technologies that direct
individual behavior. Lucas
suggested a “new classical”
approach to macroeconomics,
offering a partial return to the
pre-Keynesian world. Later “real
business cycle” models claimed
that changes in employment are
driven by changes in “real” labor
factors, such as productivity
increases or changes in people’s
preferences for leisure over work.
The critical feature of both real
business cycles and new classical
models is that they model the
macroeconomy on the result of
individuals’ rational behavior.
Although people do not have
entirely rational expectations in
reality, the assumption that they do
helps economists to build workable
models that are useful guides to the

functioning of the economy.

Rational expectations have come

under criticism by behavioral

economists who work on more

psychologically realistic models. ■

POST-WAR ECONOMICS

John Muth

US economist John Muth was

born in 1930. He studied

industrial engineering at

Washington University in St.

Louis, then mathematical

economics at Carnegie Mellon

(then called Carnegie Tech) in

Pittsburgh. Carnegie had an

extraordinary faculty in the

1950s, when Muth studied for

his PhD there—it included

future Nobel laureates Franco

Modigliani, John Nash, Herb

Simon, and later Robert Lucas.

Muth’s first paper on

rational expectations was

published in 1961 and was

little noticed at the time. A

shy, modest man, Muth was

unable to find a publisher for a

later article on the subject and

so moved on to work in other

fields, producing seminal work

in the field of operations

management and artificial

intelligence. Other economics

researchers such as Lucas and

Simon furthered Muth’s work

on rational expectations and

won major awards for their

contributions, but Muth

remained unacknowledged by

the wider world. He went on

to teach at Michigan State and

Indiana, both universities that

lacked status but allowed him

to satisfy his broad intellectual

curiosity. He is considered to

be the father of the “rational

expectations revolution.”

Muth died in 2005.

Key works

1960 Optimal Properties

of Exponentially

Weighted Forecasts

1961 Rational Expectations

and the Theory of

Price Movements

1966 Forecasting Models

The benefits of inflation

derive from the use of

expansionary policy to

trick economic agents

into behaving in socially

preferable ways even

though their behavior

is not in their own interest.

Robert Hall

US economist (1943– )