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The Rational Expectations Hypothesis Economics Essay

In this assignment, the different economics will be briefly explained and there will be a critical analysis of how the economic model describe by several economist like Adam Smith, John Keynes Maynard and Milton Friedman among others addresses the macroeconomic issues that is how do we decide what to produce with our limited resources, How do we ensure stable prices and full employment of our resources, and how do we provide a rising standard of living both for ourselves and for future generations.

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The different views will be analysed and its implication to the level of consumption, the level of saving and the level of investment in an economy will be made with the support of relevant graphs. Therefore, it will be seen how the different economic model impact on the level of the aggregate demand and aggregate supply in an economy.

Classical Economics

The Classical School of economic theory began with the publication in 1776 of Adam Smith’s monumental work, The Wealth of Nations. It book identified land, labor, and capital as the three factors of production and the major contributors to a nation’s wealth. In Smith’s view, the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace.

He described the market mechanism as an “invisible hand” that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole. Smith incorporated some of the Physiocrats’ ideas, including laissez-faire, into his own economic theories, but rejected the idea that only agriculture was productive.

While Adam Smith emphasized the production of income, David Ricardo focused on the distribution of income among landowners, workers, and capitalists. Ricardo saw a conflict between landowners on the one hand and labor and capital on the other. He posited that the growth of population and capital, pressing against a fixed supply of land, pushes up rents and holds down wages and profits.

Thomas Robert Malthus used the idea of diminishing returns to explain low living standards. Population, he argued, tended to increase geometrically, outstripping the production of food, which increased arithmetically. The force of a rapidly growing population against a limited amount of land meant diminishing returns to labor. The result, he claimed, was chronically low wages, which prevented the standard of living for most of the population from rising above the subsistence level. Malthus also questioned the automatic tendency of a market economy to produce full employment. He blamed unemployment upon the economy’s tendency to limit its spending by saving too much, a theme that lay forgotten until John Maynard Keynes revived it in the 1930s.

Coming at the end of the Classical tradition, John Stuart Mill parted company with the earlier classical economists on the inevitability of the distribution of income produced by the market system. Mill pointed to a distinct difference between the market’s two roles: allocation of resources and distribution of income. The market might be efficient in allocating resources but not in distributing income, he wrote, making it necessary for society to intervene.

In short those economists who believe in the classical economics belong to a school of thought says that full employment is the norm and there is a need for laissez faire economy.

In classical model in aggregate demand would immediately lead to falling prices ang wages, so that the real GDP would be maintained and employment would not fall. Higher aggregate demand would lead to inflation with no change in output,

They also promote a vertical aggregate supply curve as they think that the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace and as a result they have a stable aggregate demand. Moreover, they believe that the real output depends upon another main assumption which is based on Say’s Law: supply creates its own demand – that is, aggregate production will generate an income enough to purchase all the output produced.

If all the income created in the act of producing output is spent by the households, supply will have created its own demand, and all the output will be sold.

Another postulate of classical economics is the equality of savings and investment, assuming that flexible interest rates will always maintain equilibrium. Therefore it is responsive and responsive and they use the price and wages to illustrate the concept.

Keynesian Economics

On the other hand reacting to the severity of the worldwide depression, John Maynard Keynes in 1936 broke from the Classical tradition with the publication of the General Theory of Employment, Interest, and Money. The Classical view assumed that in a recession, wages and prices would decline to restore full employment. Keynes held that the opposite was true. Falling prices and wages, by depressing people’s incomes, would prevent a revival of spending. He insisted that direct government intervention was necessary to increase total spending.

Keynes’ arguments proved the modern rationale for the use of government spending and taxing to stabilize the economy. Government would spend and decrease taxes when private spending was insufficient and threatened a recession; it would reduce spending and increase taxes when private spending was too great and threatened inflation. His analytic framework, focusing on the factors that determine total spending, remains the core of modern macroeconomic analysis.

He believes that Active government policy is needed to stabilize the economy and that the “Laissez-Faire” is subject to recessions and widespread unemployment. This is why it has an aggregate demand curve which is unstable as Investment fluctuates. Moreover, the Prices and Wages Downwardly Inflexible and Horizontal Aggregate Supply Curve are to Full-Employment.

The graph shows that the quantity demanded will shift from Qf to Qu as the will be full capacity in order to stimulate increasing output and it will try to keep stable. Prices and wages are downwardly inflexible because business will not let price fall easily and the workers also will not let wages fall easily. Active government policy required to stabilize the economy

There is also need for Government expenditure is needed to move the economy out of recession.

Monetarist Economics

Monetarism is an economic school of thought that stresses the primary importance of the money supply in determining nominal GDP and the price level. The “Founding Father” of Monetarism is Milton Friedman. Monetarism gained in popularity during the high inflation period of the 1970s. The theoretical foundation for Monetarism is the Quantity Theory of Money.

Monetarists believe that the economy is inherently stable. Therefore, laissez-faire is often the best policy. Moreover, the Federal Reserve should follow fixed rules in conducting monetary policy. The Equation of Exchange states that M x V = P x Y.

Monetarists transform the equation of exchange into the Quantity Theory of Money by making the seemingly small assumption that velocity is stable in the short run. This implies that in the short run, changes in the money supply are the dominant forces that change nominal GDP. In the long-run, the economy is at potential output, so changes in the money supply only lead to higher prices, not higher output.

Monetarists believe in a set of rules that the Fed must follow. In particular, Monetarists prefer the Money growth rule: The Fed should be required to target the growth rate of money such that it equals the growth rate of real GDP, leaving the price level unchanged.

Monetarists and members of the currency school argued that banks can and should control the supply of money. According to their theories, inflation is caused by banks issuing an excessive supply of money. According to proponents of the theory of endogenous money, the supply of money automatically adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on which loans are made.

Monetarism is an economic school of thought, velocity is stable, and the amount of goods/services that can be produced is fixed in the short run. Moreover, if the Federal Reserves increases the Money Supply by 15%, we will see a proportional 15% increase in prices. Ultimately the velocity and the quantity aren’t in the equation & a change in Money supply will result in a change in Price.

New Keynesian Economics

Most economists believe that short-run fluctuations in output and employment represent deviations from the natural rate, and that these deviations occur because wages and prices are sticky. New Keynesian research attempts to explain the stickiness of wages and prices by examining the microeconomics of price adjustment.

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Renewed interest in fiscal policy has increased the use of quantitative models to evaluate policy. Because of modelling uncertainty, it is essential that policy evaluations be robust to alternative assumptions. We find that models currently being used in practice to evaluate fiscal policy stimulus proposals are not robust. Government spending multipliers in an alternative empirically-estimated and widely cited new Keynesian model are much smaller than in these old Keynesian models; the estimated stimulus is extremely small with GDP and employment affects only one sixth as large.

In the new Keynesian Economics there is higher government spending that keeps on adding to GDP while in the other hand the Old Keynesian has a diminishing effect on GDP as non-government components are crowded out by government spending. The term “new Keynesian” is used to indicate that the models have forward looking, or rational, expectations by individuals and firms, and some form of price rigidity, usually staggered price or wage setting. The term also is used to contrast these models with “old Keynesian” models without rational expectations. New Keynesian models are commonly taught in graduate schools because they capture how people’s expectations and microeconomic behaviour change over time in response to policy interventions and because they are empirically estimated and fit the data.

There are externalities to price adjustment: A price reduction by one firm causes the overall price level to fall (albeit slightly). This raises real money balances and increases aggregate demand, which benefits other firms. Menu costs are the costs of changing prices (e.g., costs of printing new menus or mailing new catalogues). In the presence of menu costs, sticky prices may be optimal for the firms setting them even though they are undesirable for the economy as a whole.

In recessions, output is low, workers are unemployed, and factories sit idle. If all firms and workers would reduce their prices, then economy would return to full employment. But, no individual firm or worker would be willing to cut his price without knowing that others will cut their prices. Hence, prices remain high and the recession continues.

Main reasons for stick prices result from surveys of managers namely the coordination failure: firms hold back on price changes, waiting for others to go first. Firms delay raising prices until costs rise. Firms prefer to vary other product attributes, such as quality, service, or delivery lags. Implicit contracts: firms tacitly agree to stabilize prices, perhaps out of ‘fairness’ to customers.

New Classical Economics

The main elements of the early new classical approach to macroeconomics can be summed as the joint acceptance of the three main sub-hypotheses involving

the rational expectations hypothesis;

the assumption of continuous market clearing; and

The Lucas (‘surprise’) aggregate supply hypothesis.

It include complete and continuous wage and price flexibility ensure that markets continuously clear as agents exhaust all mutually beneficial gains from trade, leaving no unexploited profitable opportunities. From this changes in the quantity of money should be neutral and real magnitudes will be independent of nominal magnitudes. Yet empirical evidence shows there is at least a short run positive correlation between real GDP and the nominal price level and negative correlation between inflation and unemployment (Philips curve). The discrepancy from the empirical evidence and theory on the neutrality of money was explained by Lucas in “Expectations and the Neutrality of Money” in 1972. The key insight was to change the classical assumption that economic agents have perfect information to an assumption that agents have imperfect information.

In other words, New Classical Economics accepts model of Government Expenditure with no imperfections. Its prices are perfectly flexible, and all markets are permanently cleared (S=D). All markets are self-correcting. Individuals do not leave prices at “false” levels since this would result in disadvantages. Equilibrium is optimal because present actions entail future consequences, all agents deliberately form rational expectations that is, they exploit all available information at all times since it is in their best interests to do so.

Moreover, agents adjust their decisions and actions so that their plans will be fulfilled optimally when their expectations are correct therefore, expectations (and information) play the dominant role in determining the state of the economy at any point in time. People habitually suffer from errors that explain economic fluctuations. Fluctuations and unemployment can be traced to voluntary deviations of supply and demand. Thus the business cycle is an equilibrium phenomenon, and is therefore optimal.

Neo Classical Economics

Neoclassical economics is essentially continuous with classical economics. To scholars promoting this view, there is no hard and fast line between classical and neoclassical economics. There may be shifts of emphasis, such as between the long run and the short run and between supply and demand and the neoclassical concepts are to be found confused or in embryo in classical economics. To these economists, there is only one theory of value and distribution. Alfred Marshall is a well-known promoter of this view. Samuel Hollander is probably its best current proponent.

Still another position sees two threads simultaneously being developed in classical economics. In this view, neoclassical economics is a development of certain exoteric (popular) views in Adam Smith. Ricardo was a sport, developing certain esoteric (known by only the select) views in Adam Smith. This view can be found in W. Stanley Jevons, who referred to Ricardo as something like “that able, but wrong-headed man” who put economics on the “wrong track”. One can also find this view in Maurice Dobb’s Theories of Value and Distribution. Since Adam Smith: Ideology and Economic Theory (1973), as well as in Karl Marx’s Theories of Surplus Value.

The above does not exhaust the possibilities. John Maynard Keynes thought of classical economics as starting with Ricardo and being ended by the publication of Keynes’ General Theory of Employment Interest and Money. The defining criterion of classical economics, on this view, is Say’s law.

One difficulty in these debates is that the participants are frequently arguing about whether there is a non-neoclassical theory that should be reconstructed and applied today to describe capitalist economies.


To conclude it can be said that economic theories are constantly changing. Keynesian theory, with its emphasis on activist government policies to promote high employment, dominated economic policymaking in the early post-war period. But in the late 1960s, troubling inflation and lagging productivity prodded economists to look for new solutions. From this search, new theories emerged namely the Monetarism updates the Quantity Theory, the basis for macroeconomic analysis before Keynes. It reemphasizes the critical role of monetary growth in determining inflation.

Rational Expectations Theory provides a contemporary rationale for the pre-Keynesian tradition of limited government involvement in the economy. It argues that the market’s ability to anticipate government policy actions limits their effectiveness.

Supply-side Economics recalls the Classical School’s concern with economic growth as a fundamental prerequisite for improving society’s material well-being. It emphasizes the need for incentives to save and invest if the nation’s economy is to grow.

These theories and others will be debated and tested. Some will be accepted, some modified, and others rejected as we search to answer these basic economic questions.

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