Macroeconomic Policy Under Rational

Expectations Hypothesis (REH)

By Agba Dominic

and

The REH : An Assessment on its real world

application
By Santiago Tobon
 Rational Expectations Hypothesis
The rational expectations hypothesis (REH) is
undoubtedly the most salient characteristic of the
new classical economics and in fact a crucial
assumption is new classical Models, which the
rational expectations school assumes that
economics agents act rationally when they form
their expectations of the future.
Rational expectation holds the view that
individuals acquire, process and act on relevant
economic information in their self interest.
They dont agree with complete wage and price
flexibility
 Keynessian or Monetarist
Its analysis: the increase in money supplay
leads to an increase in employment and
output in the short run
That is until labor suppliers correctly perceive
the increase in the price level that results from
the expansionary money policy action.
Expectations about prices are bacward-looking
depending on the past behaviour of prices and
adjusting only slowly to current conditions
Implication of Ratex for AD and AS analyses
short run response to anticipated policy
 Empirical challenges
Two main elements of REH :
1. What happens in reality is a consequnce of
agents expectations
2. Macroeconomic models on Ratex is actually
derived directly from the expectations
specification (limited condition)
 Drawbacks and weaknesses
The inability of economic agents to learn required
information and formulate the correct model of
the economy serious problem
Ratex assumptions require economic agents to be
superior statisticians to analyzing the future
GE in economy
Ratex School fails to provide any empirical basis
for abandoning the keynesian explaination of
unemployment (Pesaran, 1982)
 Drawbacks and weaknesses
The continous market clearing assumption is also
unrealistic since agent confront quantity
constraints in both labor and comodity markets.
The central aim to develop models which answer
specific questions under artificial and unreal
conditions
Agents expectations determine the actual
behaviour of the economy stands for irrelevance
of reality in macroeconomic models
 Suggestions
In time when innovation plays such an
important role in economics and human
evolution New conceptualizations are
needed in order to take into account
endogenous characteristics in individual
decision process and behaviour.
Contd
To improve the scope of macroeconomic
models and providing a better understanding
of economic phenomena, there will be need
to be tested again elements such as
representative agent, perfect competition and
rational expectations.