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The concept of rational expectations was first introduced by John F. Muth in his paper "Rational Expectations and the Theory of Price Movements" published in 1961. Robert Lucas and Thomas Sargent further developed the theory in the 1970s and 1980s which became seminal works on the topic and were widely used in microeconomics.
However, the rational expectations assumption is controversial since it may exaggerate agents' understanding of the economy. The cobweb model serves as one of the best examples to illustrate why understanding expectation formation is so important for understanding economic dynamics, and also why expectations are so controversial in recent ...
Lucas (1972) incorporated the idea of rational expectations into a dynamic macroeconomic models. The agents in Lucas's model are rational: based on the available information, they form expectations about future prices and quantities, and based on these expectations they act to maximize their expected lifetime utility. [ 18 ]
Part of this adjustment may involve the adaptation of expectations to the experience with actual inflation. Another might involve guesses made by people in the economy based on other evidence. (The latter idea gave us the notion of so-called rational expectations.) Expectational equilibrium gives us the long-term Phillips curve.
Muth showed that agents making decisions based on rational expectations would be more successful than those who made their estimates based on adaptive expectations, which could lead to the cobweb situation above where decisions about producing quantities (Q) lead to prices (P) spiraling out of control away from the equilibrium of supply (S) and ...
An early test of the permanent income hypothesis was reported by Robert Hall in 1978, and, assuming rational expectations, finds consumption follows a martingale sequence. [25] Hall & Mishkin (1982) analyze data from 2,000 households and find consumption responds much more strongly to permanent than to transitory movements of income, and ...
The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.
The unbiasedness hypothesis states that given conditions of rational expectations and risk neutrality, the forward exchange rate is an unbiased predictor of the future spot exchange rate. Without introducing a foreign exchange risk premium (due to the assumption of risk neutrality), the following equation illustrates the unbiasedness hypothesis.