Rational

Expectations
Hypothesis
Riddhi, Moxada, Aashutosh, Netra, Rakshya
 Background

● The idea:people use a) rationality, b) available information and c) past

experiences to make economic decisions.
● The implication: a) people will anticipate the impact of monetary policies
and adjust their decisions accordingly, b) nullifying the intended impact of
monetary policies.
● The rational expectations theory originated in the 1960s and revolutionized
the economy in the 1970s.
 Background Cont;

● Economic theory used to explain how individuals make

predictions about the future based on all the available
information.
● Individuals will also learn from past trends and experiences for
making the possible prediction about what will happen.
● Past outcomes influence the future outcomes.
 Example

A business owner deciding whether to expand his/her business. For

taking decision, the businessperson evaluates current market trends and
economic conditions (inflation rate, interest rate, exchange rate),
competition in the market, consumer demands trends, past experiences
and various other factors to assess the likely profitability of an
expansion. Based on all these factors and their proper analysis, the
business owner decides whether to investing an expansion.
 Role of Rational Expectations Hypothesis

● Before the origination of rational expectations theory, Keynes theory was

widely in practice.

Fiscal
policies
Government policies
Keynes and taxes
theory
Monetary
policies
Money supply
 Role of Rational Expectations Hypothesis

● The need for a new theory to revise or replace the Keynesian theory in the
real economy arose when it could not explain the stagnation during the
1970s, where both high inflation and high unemployment co-existed.
● The expectations theory explained stagflation by explaining people’s
behaviour as forward looking rather than adaptive.
Role of Rational Expectations Hypothesis

● As explained by Keynesian theory, when the government makes policies that

were inflation inducing, people will adapt to the situation by agreeing to
work for lower wages to secure employment. This did not explain
stagflation
● Expectations theory explained that people would anticipate inflationary
effects of government policies that results in workers demanding higher
wages to counter the inflationary effects, resulting in higher unemployment.
Role of Rational Expectations Hypothesis

● Rational expectations theory believes that people will use the information
and resources available to them to their best interests.
● For example, if the central bank is substantially increasing their money
supply then the actors of the economy will expect inflation to occur.
● Central banks thus incorporate this understanding into their policy making
procedures.
Role of Rational Expectations Hypothesis

● The government as well as central bank, in response to people’s rational

engagement in the economy will be more transparent in their activities to
make sure their activities are in line with people’s expectations about the
economy.
● If not, their credibility will decline along with the effectiveness of their
policies.
● This is more particular to the case of inflation targeting.
Role of Rational Expectations Hypothesis

● Government interventions and policies can impact asset prices and influence
investor behaviour based on expected outcomes.
● The market along with the people become forward-looking, making
economic decisions based on expectations of how the economy will look in
the future.
● Rational expectations theory guides risk management strategies.
 Adaptive Expectation Hypothesis

● This theory gives importance to past events in predicting future outcomes.

● People can predict from past events.
● Example: If inflation is increased by 2% every year, then it can be predicted
that inflation will also be increased by 2% this year.
● Future is in the continuation of past.
● Also known as ‘backward working approach’/ alternate of Rational
Expectation Hypothesis.
 Anticipated Policy
● Anticipated policy refers to measures or actions that are expected and planned.
● This involves policies with clear, predictable outcomes.

People anticipate the impact of the

contractionary policy when it is
undertaken, so that the short-run
aggregate supply curve shifts to the right
at the same time the aggregate demand
curve shifts to the left. The result is a
reduction in the price level but no
change in real GDP; the solution moves
from (1) to (2).
 Effects of Anticipated Policy in Alternative
Framework
● Anticipatory Action When policy actions are anticipated, individuals adjust
their behavior ahead of time, mitigating the policies intended impacts.
● Reduced Volatility Anticipated policies lead to smoother economic
transitions, as individuals prepare themselves for the expected changes.
● Enhanced Efficiency Anticipatory actions increase the speed and
effectiveness of policy implementation, minimizing potential disruptions.
 Anticipated Policy in terms of Nepal
In the recent fiscal year 2080-81 BS, Nepal Rastra Bank (NRB) has unveiled few
anticipated monetary policies.

● The bank rate remains steady at 7.5 percent, emphasizing the NRB's
commitment to maintaining financial stability and controlling inflation.
● Enhancing liquidity in the banking system, the deposit collection rate has been
lowered to 4.5 percent, providing an excellent opportunity for banks to collect
more deposits.
● The NRB is actively supporting first-time homebuyers by increasing the loan
limit from Rs. 1.5 crore to Rs. 2 crore, making it easier for them to own a
residential property and enter the real estate market.
 Macroeconomic Variables in Anticipated Policy

● Anticipated policies can bring change to the following macroeconomic

variables:
1) Investment: When businesses anticipate policy changes such as tax
incentives or regulatory shifts, they can strategically plan investments. For
example, If government signals a reduction in corporate taxes, companies
may decide to expand or invest in new projects.
2) Consumption: For instance, if individuals anticipate a decrease in income
tax, they might be inclined to spend rather than save. Consumers may adjust
their spending based on expectations of future policy changes.
 Macroeconomic Variables in Anticipated Policy
3) Interest Rates: Anticipated changes in monetary policy, like interest rate
adjustments, can impact borrowing costs. If people expect interest rates to rise,
they may be more hesitant to take out loans or make large purchases, affecting
overall economic activity.

4) Exchange Rates: Anticipation of policy changes, especially in terms of trade,

can influence exchange rates. If a country decides a tightening of monetary
policy, its currency may strengthen as investors seek higher returns.

5) GDP: There is no change in real GDP as the price level fluctuates.

 Unanticipated Policy
● Unanticipated policy refers to actions or changes in policy that are unforeseen or
unexpected.
● It does not follow Rational Expectation Hypothesis.

Suppose the economy is initially in equilibrium at point 1.

Real GDP equals its potential output, YP. Now suppose a

reduction in the money supply causes aggregate demand

to fall to AD2. In our model, the solution moves to point 2;

the price level falls to P2, and real GDP falls to Y2. There is

a recessionary gap. In the long run, the short-run

aggregate supply curve shifts to SRAS2, the price level

falls to P3, and the economy returns to its potential output

at point 3.
 Unanticipated Policy

● For example: If government predicts that increase in price will increase in

employment (one of the 10 principles of economics).
● If existing labour demand to increase their wages as future price will increase. If
wages of existing workers are increased but there is no change in employment as
producer didn’t demand more workers.
● So the policy government to increase employment is predicted but doesn’t affect
unemployment.
 Effects of Unanticipated Policy in Alternative
Framework
● Shock and Adjustment Unanticipated policies trigger temporary shocks in
the economy, demanding immediate adjustments from market participants.
● Inefficiencies and Deadweight Loss Unpredicted policy changes lead to
misallocation of resources and deadweight loss as individuals struggle to
adapt.
● Market Distortions Unanticipated policies can result in market distortions
and unintended consequences, disrupting the equilibrium.
 Macroeconomic Variables in Unanticipated Policy

Unanticipated policy can bring change in the following macroeconomic

variables:

1) Market Volatility: Sudden, unexpected policy announcements can lead to

market shocks. Investors may react hostility, causing price fluctuations and
increased volatility in financial markets.
2) Confidence: Unanticipated policy changes can shake business and consumer
confidence. If there’s uncertainty about the direction of policies, businesses
may delay investments, and consumers might reduce spending due to
concerns about the future economic environment.
 Macroeconomic Variables in Unanticipated Policy

3) Inflation: Unanticipated policy shifts in monetary policy can influence inflation

expectations. For example, a surprise interest rate hike might lead to lower inflation
expectations as borrowing becomes more expensive.

4) Unemployment: Sudden policy changes can impact industries differently, affecting

employment levels. For instance, unexpected regulatory changes may lead to job losses in
sectors.

5) GDP: There is change in real GDP as the price level fluctuates.

 References
● Reading: New Classical Economics and Rational Expectations | Macroecon
omics (lumenlearning.com)
● https://youtu.be/-7Riuk2B4i4?si=NZuKOK6rgk6l9J5t
● https://youtu.be/EDXaAyhVhl4?si=lviBINn6N1M2TBHm
● Exciting News! The Nepal Rastra Bank (NRB) has recently unveiled its highl
y anticipated monetary policy for the fiscal year 2080/81! 🇳🇵🏦 (linkedin.co
m)
● https://youtu.be/jCn7Qqo6FTA?si=6gP55KbFehPYJZcb
● https://www.britannica.com/topic/theory-of-rational-expectations