Question

Understand the rational expectations hypothesis and its policy implications.

Short answer

Expectations and outcomes have a mutual influence. There is a constant flow of information from previous outcomes to current expectations. The way the future emerges from the past tends to be stable in recurring situations, and people alter their projections to fit this steady pattern.

Step-by-step solution

Step :1 Introduction 

The rational expectations theory is a widely used idea and modelling tool in macroeconomics. According to the theory, people make judgments based on three essential factors: their human rationality, the information available to them, and their prior experiences.

People's current economic expectations, according to this theory, can influence what the economy becomes in the future. This runs counter to the idea that government policy influences financial and economic decisions.

Step :2 Explanation 

According to the reasonable expectations hypothesis, people construct inflation expectations based on all available previous and present knowledge as well as a grasp of how the economy works.

If pure competition reigns supreme, wages and prices are flexible, and individuals fully anticipate policymakers' intentions, actual GDP is unaffected by anticipated policy measures.

Technological advancements and labour market shocks, such as changes in the labour force composition, can cause actual business cycles, which undermine the argument for active policymaking.