Question: Rational expectations theory: a. explains the relationship between the unemployment rate and inflation. The rational expectations theory of expectations -that individuals form expectations optimally on the basis of the in- formation available to them and the costs of using that information-has become and will remain the leading theory of expectations.2 But there is nothing inherent in the hypothesis that implies that activist policy is This behavior is shown to be consistent with a rational expectations equilibrium in a discretionary environment where the policymaker pursues ... implies that the long-run mean of the natural unemploymentrate is lim E(U+1IIti) n, a constant. According to them, the assumption implicit in Friedman’s version that price expectations are formed mainly on the basis of the experience of past inflation is unrealistic. Rational expectations suggest that people will be wrong sometimes, but that, on … Rational Expectations Theory and Macroeconomic Analysis •Implications of rational expectations for macroeconomic analysis: 1.Expectations that are rational use all available information, which includes any information about government policies, such as changes in monetary or fiscal policy 2.Only new information causes expectations to change This implies that to project the long-run effects of a policy change, one must calculate the change induced in the stochastic process, accounting for the fact that private sector forecasting rules change. 2.2 Savage and rational expectations. The contribution of rational expectations theory to the long-run model is the understanding that: A) economists must support the use of tax policy for long-run growth. B) the response of the public to policy changes makes the economy return to long-run equilibrium more quickly. Rational expectations theory implies that the: a. aggregate demand curve is vertical. C) the long-run model can rarely be applied. c. long-run aggregate supply curve is horizontal. Rational Expectations Rational Expectations Rational expectations is an economic theory that states that individuals make decisions based on the best available information in the market and learn from past trends. Figure 17.9. In the long run, the short-run aggregate supply curve shifts to SRAS 2, the price level falls to P 3, and the economy returns to its potential output at point 3. Lucas … Contractionary Monetary Policy: With and Without Rational Expectations. D) the economy remains in short-run equilibrium longer. 99. Robert E. Lucas Jr.: An American economist who won the 1995 Nobel Memorial Prize in Economic Sciences for his research on rational expectations. Under rational expectations, therefore, the long-run instability threatened by inconsistent policies becomes an immediate one: it is impossible even to define an equilibrium path. Thus fiscal deficit policy implies bounds on feasible monetary policy. Economists belonging to the rational expectations (Ratex) school have denied the possibility of any trade-off between inflation and unemployment even during the long run. 26. b. long-run aggregate supply curve is vertical. b. explains why prices are flexible in the long run. Explain how the theory of rational expectations means that demand management policy is ineffective Adaptive versus Rational Expectations The natural rate hypothesis, which we learned about in an earlier section, argues that while there may be a tradeoff between inflation and unemployment in the short run, there is no tradeoff in the long run.