Expectations: Theory and Evidence by K. Holden

By K. Holden

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There has been an immense amount of research over the past decade investigating the implications of the rational expectations hypothesis for economic behaviour, and so our choice of topics for discussion will be somewhat less than comprehensive and will be introductory in nature. The reader requiring a more detailed consideration of these issues is strongly recommended to consult the specialist books by Begg (1982), Lucas and Sargent (1981), or Minford and Peel (1983). The plan of the chapter is as follows.

This will depend on the nature of the behavioural equations in which the assumption of rational expectations is embodied. There is no reason in principle why a 'Keynesian disequilibrium model' cannot embody rational expectations. Consequently, the general case for activist stabilisation policy must be based on a consideration of the welfare properties of such a policy, and not on the sole consideration of how the expectations are formed - see Sargent (1979a), Minford and Peel (1983). Of course, if expectations are formed rationally rather than in some mechanistic manner this can dramatically change the nature of the evolution of an economy in response to changes in government policy.

It is often stated that incorporation of the rational expectations hypothesis into the specification of a macroeconomic model leads inevitably to the proposition that stabilisation policy is ineffective. Intuitively, it may be thought that economic agents out-guess the government and anticipate policy changes. In fact, this proposition is a special result which depends on a restrictive specification of the behavioural equations of the model. To illustrate this, we will use a simple macroeconomic model which is more monetarist in concept than the previous Keynesian multiplier/accelerator model.

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