Free Economics Dissertations - It Is In Recognition Of These Difficulties, That Various Approaches Have Been
It is in recognition of these difficulties, that various approaches have been adopted in carrying out empirical test of this theory (Shaw, 1987).
Barro (1977) tested the rational expectations hypothesis. He attempted to show that it is only the unanticipated component of monetary growth that affects employment, real output, and the price level. He used annual data from the USA covering the period 1941 to 1973. In accordance with certain theoretical considerations and after some empirical experimentation, he obtained a measure of anticipated monetary growth. He then computed the unanticipated component of monetary growth in each period as the difference between actual monetary growth in the period and the anticipated component of monetary growth in that period. His statistical tests all seem to support one of the main predictions made by the simple rational expectations model: that it is unpredictable monetary growth that is important in the determination of the level of unemployment and that predictable monetary growth is irrelevant.
THE NEW KEYNESIAN
Keynesian theories of expectations assume that expectations are slow to change. The theory of extrapolative expectations says that expectations depend on extrapolations of past behaviour and respond only slowly to what is currently happening to costs. In one simple form of the theory, the expected future inflation rate is merely a moving average of past actual rates.
The rationale is that, unless a deviation from past trends persists, firms and workers will dismiss the deviation as transitory. They will not let it influence their wage and price setting behaviour.
The theory of adaptive expectations in this context states that the expectation of future inflation rates adjusts to the error in predicting the current rate. Thus, if you thought the current rate was going to be 5% and it turned out to be 10% you might revise your estimate of the next period’s inflation rate upwards by, say, half of your error, making the new expectation 7.5%.
The two theories make expectations about future inflation depend on past actual rates. In an obvious sense such expectations are backward-looking, since the expectation can be calculated using data on what has happened already. Backward-looking expectations are overly naïve. People do look ahead to the future and assess future possibilities rather than just blindly reacting to what has happened before.
In modelling expectations of a variable under the Keynesian theory, the simplest assumption is that the expected rate of change of the variable over the next time period will be the same as the change which has occurred over the previous period, so that,
EtX t + 1= Xt(1.1)
Where
X=Price
EtX t + 1=expected rate of change of X from period t to t + 1
Xt=actual rate of change of the X from t 1 to t
This was used by among others, Turnovsky (1972).
Dissertations - Free Economics Dissertations
