Rational Expectations |

The Keynesian model of, say, 1965, didn't pay too much attention to expectations: they were assumed to be static and exogenous. In 1968, Friedman and Phelps pointed out just how misleading it can be to have such a cavalier attitutude to expectations. They applied a particular model of expectations formation, adapative expectations, to macroeconomics. It looked empirically to be pretty successful. |

But adaptive expectations is thoeretically unsatisfying. When there is a change in the economic environment, the theory of adapative expectations implies that people will make systematic and predictable mistakes. If you can forecast your mistakes, surely you can also correct them. |

Beginning in 1972 with work by Robert Lucas, macroeconomics moved toward a different way of modeling expectations, using the concept of rational expectations (RE). The basic principle of RE is that, if we assume that firms optimize over input choices, and consumers optimize over consumption choices, it is methodologically consistent to assume also that individuals optimize over their use of information. The practical implication of this is that a model of RE asumes that any mistakes that are made are unpredictable: they are random. |

From such a simple idea, RE revolutionized the way researchers thought about macroeconomics. On the practical side it required new mathematics tools, and forced researchers to write down much more carefully-crafted mathematical models of the economy. But RE also had profound implications in terms of the predictions it made about behavior and policy. |

In this section, we look at some of these mathematical tools, and some of the profound implications. We will look at three, out of many possible, applications of RE to macroeconomic issues that were hitting the presses in the mid-1970s. The ones we look at have had a particularly deep impact on the profession. |

Download transparencies for this section here. |

Review questions for this section can be found here. |

1. Introduction
The problem with static
models.
The problem with adaptive expectations. A lame economics joke. The concept of rational expectations. Solving RE models by the method of undetermined coefficients. |

2. Applications
Money neutrality and the optimal money supply rule. (Sargent and Wallace, 1975) The concept of time inconsistency (Kydland and Prescott, 1977). Ricardian equivalence (Barro, 1974) |