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The Controversy Over Rational Expectations

Published online by Cambridge University Press:  26 March 2020

David G. Mayes
David G. Mayes*
Affiliation:
National Institute of Economic and Social Research
*
∗This article was written at the suggestion of the Editorial Board and incorporates substantial contributions from colleagues at the Institute.
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Abstract

The purpose of this article is to examine in a non-technical manner the contribution of the hypothesis of rational expectations to the explanation of how people form expectations of the values of economic variables. In particular the article draws conclusions for what the hypothesis may and may not imply for the formation of macroeconomic policy in the United Kingdom. There is a short annotated biblography at the end of the article.

Type
Articles
Information
National Institute Economic Review , Volume 96 , May 1981 , pp. 53 - 61
Copyright
Copyright © 1981 National Institute of Economic and Social Research

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References

(1) For ease of reading, the references made in the text to previously published work are explained in a bibliography at the end of the article. This sets out a number of possible further references which the reader might like to use in following up the points made in this discussion.

(2) 2 April 1980, p. 43 of Minutes of Evidence taken before the Treasury and Civil Service Committee.

(1) There are theoretical treatments of the optimal rate of saving, for example those stemming from the work of Ramsey in 1926.

(1) It is important to note at this point that expectations can be formed in one time period about the value of a variable in the same period as well as in future time periods. In practice we can only observe behaviour over a finite time interval. Therefore, although we can observe the price at which trading took place after the event, sellers may not have known the trading price when they put up the particular quantity of their goods for sale. This is true, for example, of fishermen presenting their catch for sale in the quayside market. Trivially, of course, if past values are not known we can hold expectations about their values.

(2) In a sense, therefore, the other variables are acting as instruments.

(3) This problem of identification of the two influences is in principle surmountable if the expectations are held only about a distinct future time period.

(4) Or rather one's recollection of what was charged last time, which might not be correct.

(5) This merely asserts that it is possible to earn economic rents which are not bid away during the time period under scrutiny.

(1) He also writes later on the same page: ‘expectations [of firms] (or more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the ‘objective’ probability distribution of out comes)'.

(1) It is important not to confuse the expectation and the action based on the expectation; the argument here is that the mean value of the probability distribution of predicted out come is not what constitutes the ‘expectation’-i.e. the mathe matical expectation and the economic concept of an expectation are not identical.

(1) Given the demographic characteristics and structure of the economy this can be translated into a ‘natural rate of unemployment’.

(1) For example the government has to keep on making announcements to the effect that the money supply will not be increased, that it is determined to get inflation under control, that if trade unions ask for higher wages they will simply increase unemployment, etc., while at the same time it is in reality engaged on a programme of increased public expenditure. If the latter is to succeed in raising employment it is vital for economic commentators not to be a party to revealing that deception.

(2) This assumes that we are dealing with an open economy with flexible exchange rates; otherwise the intervention would be totally reflected in the balance of payments.

(3) The transactions demand for money is normally thought to depend upon nominal income, i.e. real output multiplied by the price level.

(4) In most cases it is likely that a small positive rate of inflation will be chosen in preference to a zero rate.

(5) In the alternative ‘fix-price’ system where prices do not adjust completely buyers may be frustrated by rationing (as in mortgage markets from time to time) or sellers frustrated, as in the labour market where an individual might be pre pared to work for less, but the wage rate is fixed nationally and hence he remains unemployed.

(6) i.e. if the economy is heavily affected by fix-price rather than flex-price markets.

(1) ‘Mark I’ monetarists to use Tobin's phraseology.

(2) see p. 61.

(3) Modigliani has used the term ‘non-irrational’ for these alternative schemes of expectation formation.

(4) See A.P.L. Minford and D. Peel, ‘Is the government's economic strategy on course?’, Lloyds Bank Review, April 1981 for a very recent example.