Rational Expectations

Presented by:
Sania Shakeel Qureshi
Madiha Hanif
Amna Jamil
 INTRODUCTION

 It is a concept and theory used in macroeconomics.

 Individuals base their decisions on human rationality, information
available to them, and their past experiences.
 Economists use the rational expectations theory to explain
anticipated economic factors.
 The idea behind the rational expectations theory is that past
outcomes influence future outcomes.
 Decision make on past experiences are mostly correct.
 HISTORY

 The idea of rational expectations was first developed by American

economist John F. Muth in 1961.
 He used the term to describe the many economic situations in
which the outcome depends partly on what people expect to
happen.
 It was popularized by economists Robert Lucas and T. Sargent in
the 1970’s.
 ASSUMPTIONS

The theory states the following assumptions:

1. With rational expectations, people always learn from past
mistakes.
2. Forecasts are unbiased, and people use all the available
information and economic theories to make decisions.
3. People understand how the economy works and how
government policies alter macroeconomic variables such as
price level, level of unemployment, and aggregate output
 IMPLICATIONS & CHALLENGES

Implications
  Validity of Impotency
Result
 Property of Un-biasedness
Challenges
Unrealistic elements
Flexible prices and market
clearing mechanism
Non treatment of capital
and money:
Empirical validity:
Property of un-biasedness:
Observed behavior
V E R S I O N S O F R AT I O N A L
E X P E C TAT I O N S
 CAGAN MODEL

 How current and future money effect the real money balance. If the
real money balance demanded depend upon the cost of holding
money price level depend on both the current and future money
supply.
 Cagan model show more explicitly how this relationship works.
 Mt –pt is the log of real money balance and pt+1 – pt is the
inflation rate between period t and t+1.
 The equation state that if inflation goes up by 1 percentage point
real money balances fall by gema present.
ASSUMPTION OF CAGAN MODEL

 First by excluding the level of output as a determinant of money

demand it is implicitly assumed constant.
 Second by including the rate of inflation rather than the nominal
interest rate it is assumed that the real interest rate is constant.
 Third by including actual inflation rate rather than the expected
inflation it is assumed perfect foresight.
 First equation of Cagan model
 mt-pt=-r(pt+!-pt) (A1)
 By solving equation A1 for expressing the price level as a
function of current and future money.
 To do this note that the equation 1 can be written as
 This equation state that the current price is a weighted average
of current money supply and future money supply and the next
year price level.
 The next year price level will be determine by the same way as
the pervious price level:
 Now substitute equation A3 foe pt+1 in equation A2 to obtain
 CONTINUE
 This equation state that the current price level is a weighted
average of current money supply, next year money supply and
the following year price level as well.
 The price in period t+2 is determined in equation A2:
 Now substitute equation A5 in to equation A4 we obtain
 IF WE DO THIS INFINITE NUMBER OF TIME

 Dots indicate infinite number of analog term according to equation

A7 state that the current price level is the weighted average of the
current money supply and future money supply.
 Note that the importance of gema the parameter governing the
sensitivity of real money balances of inflation.
 The weight on the future money supply decline geometrically at rate
r/(1+r), if r is small than r?(1+r) is small and the weight decline
quickly.
 In this case the current money supply is the primary determinant of
the price level.
 CONTINUE
 If Gemma is zero we obtain quantity theory of money in the
price level is proportional the current money supply and the
future money supply do not matter at all.
 If Gemma is large than the r/(1+r) is close to 1 and the weight
decline slowly.
 In this case the future money supply play a key role in
determining the today price level.
 Finally let relax the assumption of perfect foresight. If the
future is not known with certainty.
 MONEY DEMAND FUNCTION

mt-pt=-r(Ept+1-pt) A8
Where Ept id the expected price level.
Equation A8 state that the real money balances depend on the expected
inflation. By following steps similar to those above we can show that:
Equation 9 state that the price level depend on current money supply and
expected future money supply.
Some economist use this model to argue that the credibility is important for
ending of hyperinflation because price level depend on both current and
expected future money.Inflation depend on both current and expected future
money growth. Therefore to end high inflation both money growth and
expected money growth must fall.
Expectation in turn depend on credibility in the perception that the central bank
is committed to a new more stable policy.
 HOW CAN A CENTRAL BANK ACHIEVE CREDIBILITY IN
THE MIDST OF HYPERINFLATION

Credibility is often achieved by moving the underlying cuse

of the hyperinflation the need of seigniorage.
Thus a credible Fiscal reforms often necessary for a credible
change in monitory policy. Thus fiscal reform might take the
form of reducing the government spending and making the
central bank more independent from the government.

Reduced spending decreased the need of seigniorage , while

increased independence allow the central bank to resist
government demand of seigniorage.
 SOLUTION PROCEDURE
 ɣ+αEtpt+1+(1-α)pt+μt=μ0+ μ1mt-1+et (A)
 pt is dependent on the values of mt-1 , μt , et & Etpt+1
 Etpt+1 depends on Etpt+2 & Etmt+1
 E μt+1= 0
 Future mt+1 is determined by current mt & the current mt is determined by
previous mt-1 & et
 The future mt+1 brings no additional variables
 pt = ϕ0 + ϕ1 mt-1 + ϕ2 μt + ϕ3 et (1)
 If we say the current pt is determined by these conjectures and it came up
true then
 The future pt+1 = ϕ0 + ϕ1 mt + ϕ2 μt+1 + ϕ3 et+1
 CONTINUE
Then theEtpt+1 = ϕ0 + ϕ1 mt
now putting value of mt =μ0 + μ1 mt-1+
et in above equation we’ll get
Etpt+1 = ϕ0 + ϕ1(μ0 + μ1 mt-1+ et)
Now substituting above 1 and 2 eq
into the a equation A we get
ɣ+α[ϕ0 + ϕ1(μ0 + μ1 mt-1+ et)]+(1-α)
( ϕ0 + ϕ1 mt-1+ ϕ2 μt + ϕ3 et) + μt = μ0 +  ϕ3 = = =
μ1 mt-1+ et
now by comparing the coefficients we
get
α ϕ1 μ1 + (1- α) ϕ1 = μ1 (20a)
(1- α) ϕ2 + 1 = 0 (20b)
 α ϕ1+ (1- α) ϕ3 = 1 (20c)
 ɣ+ α ϕ0 + α ϕ1 μ0 +(1- α) ϕ0= μ0
(20d)
(2)  from 20a and 20b we get ϕ1 & ϕ2
 ϕ1 =
 ϕ2 =
 ϕ0= - ɣ
now putting all value of ϕ’s
into the pt equation we get
pt = - ɣ + mt-1 - + et
 CONTINUE
evolution comes in pt over time in terms of
exogenous socks that are et & μt and the
predetermined variable mt-1 it defines a time path for
pt
pt = - ɣ + mt -
each value ’s tells us the path of pt.