Topic 7: Rational Expectations

Question 1

Who was the proponent of rational expectations and what did it build from?

Answer 1

• Work done by Robert Lucas.
• Extends cagan’s extension of Friedman’s work but:
  
  • Focuses more on price levels rather then Cagan’s focus on changes in price levels.

Question 2

What does rational expectation theory say about expectations and price modelling?

Answer 2

That the best estimate of future asset prices are the current asset prices.

Because asset prices are best modelled by a random walk with no drift, zero mean and uncorrelated error.

Question 3

What are adaptive expectations?

Show a model:

Answer 3

• The idea that expectations adapt to new information.
• E_t-1(p_t) = φp_t-1 φ(1-φ)p_t-2 φ(1-φ)²p_t-2 …

Question 4

How does Lucas explain the philips curve relationship?

Answer 4

By the equation:

p_t = (y_t - y*) + E_t-1p_t + ε_t

Which leaders to a policy ineffectiveness theorum.

Question 5

Define Lucas’s policy ineffectiveness theorum.

Answer 5

• Any systematic change in policy can be fully anticipated and neutralised through price level changes.
• Only surprises or un-predictable events can change real factors.