Question

If most people have rational expectations, how long will recessions last?

Short answer

If people have rational expectations, then the prices will be expected to fall and adjust immediately and this will, in turn, reduce the period of recession.

Step-by-step solution

Concept Introduction

If people have rational expectations, then the prices will be expected to fall and adjust immediately and this will, in turn, reduce the period of recession. The theory of rational expectations points out that even though the development won't happen immediately, the expectation would be that real estate shortly would become costly. Thus, people would be ready to pay more in the present. Hence, it is seen that the price does not remain for the event (that is the event of developing the smart city), but adjusts instantly. Hence, the people ready to pay more in the current situation may assume that economy is currently operating at potential GDP and the prices may increase more in the future, thereby worsening the future situation. So, this way of consideration can last recession.

Explanation

Suppose the economy is experiencing a recession, it would imply that the overall price level is relatively low. Then, suppose in the current situation, the government announces that it is going to develop a particular city as a smart city. This would imply that real estate prices would increase. The theory of rational expectations points out that even though the development won't happen immediately, the expectation would be that real estate soon would become costly. Thus, people would be willing to pay more in the present. Hence, it is seen that the price does not remain for the event (that is the possibility of developing the smart city), but adjusts instantly.

Final Answer 

Hence, the people ready to pay more in the current situation may assume that economy is currently operating at potential GDP and the prices may increase more in the future, thereby worsening the future situation. So, this way of thinking can last recession.