Free Economics Dissertations - Without, Assuming Randomly, Just Reasonable Approximate Expectations, Private
Without, assuming randomly, just reasonable approximate expectations, private anticipation of government action can affect the outcome of policies.
THE MONETARISTS
Monetarism is closely allied with the Classical school of thought. It is essentially an extension of Classical theory which was developed in the 1960s and 1970s to try to explain a new economic phenomenon, stagflation.
This sees expectations as determined by essentially unexplainable psychological forces. It states that inflation is determined by excess aggregate demand and price expectations; that expectations are generated by past price history and hence by previous excess demand; that excess demand results from excessive monetary growth; and therefore that excessive monetary growth, past and present is the root cause of inflation.
According to the rational expectations hypothesis, individuals will tend to exploit all pertinent information about the inflationary process when making their price forecasts. If true, this means that forecasting errors ultimately could arise only from random shocks occurring to the economy. For if the public is truly rational, it will quickly learn from these inflationary surprises and incorporate the new information into its forecasting procedures. As incorporated in monetarist models, the rational expectations will always be correct and the economy will always be at its long-run steady-state equilibrium.
Monetary advocates of the strict rational expectations view argue that it carries some radical implications for stabilization policy. Specifically it implies that systematic policy actions cannot influence real variables even in the short run, since rational agents would already have anticipated and acted upon these policies. To have an impact on output and employment authorities must be able to create a divergence between actual and expected inflation. This follows from the monetarist view that inflation influences real variables only when it is unanticipated.
The authorities must be able to alter the actual rate of inflation without simultaneously causing an identical change in the expected future rate. Thus, the only way that monetary policy can have even a short-term influence on real variables is for it to be completely unexpected. However, with stagflation the monetarist view becomes questionable as stated in the latter.
It is argued that using empirical data to test the validity of the rational expectations hypothesis, two difficulties are immediately encountered. Firstly, much of the evidence for rational expectations is sought in macroeconomic models which incorporate other assumptions, particularly price clearing scenarios. Negative findings concerning such models do not therefore invalidate rational expectations perse.
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