The rational expectations theory is an economic concept whereby people make choices based on their rational thinking, available information and past experiences. The theory suggests that the current expectations in an economy are equivalent to what people think the future state of the economy will become.
There are three assumptions of rational expectations:
- All economic actors are rationally, they have adequate information, people know that economic future will reasonably accurate, from that it will give good reaction for predicted change will occur. Based on the judgement they can control their economic behaviour.
- The price level and the rate of wages can easily change. Lack of supply of goods will increase prices, and excess supply leads to lower prices. Overpowering workers will lower their wages, instead labour shortages will increase their wages.
- All markets are perfectly competitive, and complete information will be known by all economic actors in different markets As result of this assumption, the rational expectation theory develops an analysis based on the principles contained in the microeconomic theory which also stems from the assumption that buyers, producers, and owners of production factors act rationally in carrying out their activities.
The second assumption is that all types of markets operate efficiently and can quickly make adjustments the prevailing changes How does this view on how expectation is formed differ from the assumption that workers formed expectations of current and future price levels based on past information about prices? The rational expectations view differs from the earlier assumption because the earlier assumption held that workers form expectations of current and future prices based on the information about prices only while the rational economic agents in forming a prediction of the value of the price level does or use the information of the past behaviour of prices only but all the relevant available past information.
INTAN MAZNI BINTI MADZLAN EIA
Compare the effect of expansionary monetary policy between the new Classical and Keynesian on output and employment. Expansionary monetary policy implemented money supply MS increases, interest rate r decreases and aggregate demand AD increases.
- In new classical and Keynesian, government uses this method by assuming the existence of a fully anticipated increase in MS in the market.
- When there is an increase in the money supply from the expansionary monetary policy AD will shift to the right AD0 to AD1 which raise the price level from P0 to P1 and output level from Y0 to Y1 and the equilibrium change.
- Firm increases labour demand, and this shifts the labour demand ND curve to the right from ND0 to ND1, the nominal wage W increases from WO to W1.
- Because the expected change of money supply, as the MS increases, aggregate supply AS shifts to the left from AS0 to AS1
- Equilibrium point moves from point B to point A, due to the expected change in MS, P increases from P1 to P2, output decreases from Y1 back to Y0. NS decreases, and the curve shifts to the left from NS0 to NS1.
- Equilibrium point changes from e1 to e2, the nominal wage increases from W1 to W2 and the number of workers decrease from N1 back to N0. Price increases from P0 to P2, while the output and employment remains unchanged.
