Rational Expectations in the Economy and Unemployment

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  • 0:05 Theory of Rational…
  • 3:56 Unemployment
  • 5:07 Fiscal & Monetary Policies
  • 7:23 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

This lesson provides an overview of the theory of rational expectations and then applies it to the labor market, fiscal policy and monetary policy. In the lesson, you'll learn more about expectations and outcomes in a world where people want to maximize profit.

What Is the Theory of Rational Expectations?

Join me as we visit one of the largest farms in the country. At this very moment, Fred the farmer is making a decision about how much corn to plant throughout the acres and acres of his beautiful land. If we can get inside his head and determine how he makes decisions, we could explain a lot of things about how the economy works, including prices, unemployment and the actions taken by the government and the central bank.

When Fred the farmer decides how much corn to plant each year, he's using rational expectations, which is the theory that people make guesses and develop expectations about the future that are based on all available information, not simply past experience.

Because people are forward-looking and incorporate this into their expectations, the future tends to follow their expectations. John Muth is called the father of the rational expectations revolution. His rational expectations theory was developed as a challenge to some of the ideas regarding aggregate demand from classic economist John Maynard Keynes.

As we'll see in a moment, the theory of rational expectations has some important effects on aggregate supply. More importantly, it clashes with Keynes' viewpoint that the government should intervene in the economy and argues instead for government noninterference.

Let's take a closer look at this economic theory with the help of some examples. The theory of rational expectations says that because people are forward-looking and rational (as opposed to emotional), actual outcomes will turn out to be very close to the expectations of all the players in the economy.

For example, whenever it's time for Fred to go out and plant for the year, he makes a very important decision about how much corn to plant. How much he plants depends on how much he thinks he will earn from doing so. If the price of corn is high, Fred will choose to plant more corn so he can sell it at a higher profit. If the price is low, Fred won't plant as much, because he still has to do the same amount of work for every bushel of corn, but his return will also be low.

Farmers like Fred are making the same decision across the whole economy. Fred and his peers make decisions based on two things: firstly, past experience, which is what the price of corn was before, and secondly, they make decisions based on all the information they have, such as the current price of corn. These two things form the basis of their expectations of the future, or what they think the price of corn will be in the future.

When you take all of the decisions in the economy together, you get an aggregate level of supply for corn. This aggregate supply affects the actual price of corn at harvest time, which tends to be pretty close to what all the farmers together predicted. In addition, all their profit from planting and harvesting corn ends up being pretty much what all the farmers expected it to be, assuming no major changes in price from one year to the next. So, now you see how the farmers' rational expectations about the value of their corn basically held true.

Rational Expectations and Unemployment

The theory of rational expectations can be directly applied to the labor market - specifically, what happens to unemployment. The rational expectations theory predicts that, because companies and workers rely not only on past information but also make predictions about the future, the labor market will generally be in equilibrium most of the time, so unemployment is at its natural rate. Just as the farmers more or less predicted the value of their corn, so too can companies more or less predict the proper level of employment for equilibrium.

Rational expectations theory also leads to the conclusion that, although the government can help reduce the unemployment rate, their actions will only lead to higher prices. Since unemployment is basically at equilibrium most of the time, any actions by the government to alter its level will unnaturally disrupt the economy's price level. Therefore, the government should not intervene.

Rational Expectations and Fiscal and Monetary Policies

Okay, let's take a look at one final example of the rational expectations theory. The theory applies not only to unemployment, but also fiscal and monetary policies. Because people change their behavior based on what they expect, government and central bank attempts to influence real GDP may be completely ineffective.

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