Chapter 27 - Rational expectations - Theory and policy implications. In this chapter you will learn to differentiate between rational and adaptive expectations, explain why monetary policy is ineffective under rational expectations, realize the importance of central bank credibility under rational expectations. | Chapter 27 Rational Expectations: Theory And Policy Implications Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Differentiate between rational and adaptive expectations • Explain why monetary policy is ineffective under rational expectations • Realize the importance of central bank credibility under rational expectations • Define monetary policy’s influence on interest rates under different expectations regimes Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 27-2 Introduction • Expectations in the economy play a significant role in the outcome of monetary policy – Inflationary expectations enter into wage agreements and, therefore, determine the shape of the aggregate supply curve and the Phillips curve trade-off – Expectations of monetary policy affect the timing of interest rate responses to changes in the money supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 27-3 1 Introduction (Cont.) • The models developed in earlier chapters assumed that expectations of the future are based on the past • However, this assumption ignores other pieces of information that might be important to a more accurate estimate of future Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 27-4 When are Expectations Rational? • Adaptive expectations – Assumes that inflation in the future is an extrapolation of recent price trends – Thus, if inflation has been on the increase, this suggests that people expect inflation to continue to go up – This ignores any possible countercyclical policy response by the Federal Reserve Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 27-5 When are Expectations Rational? (Cont.) • Rational expectations – People will use all available information to formulate expectations of economic variables— inflation, interest, money supply – Individuals have strong incentives to make rational forecasts and will act accordingly – If their expectations are .
