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Question from Past Macroeconomics Qualifying ExamEdit

Spring, 2002 - Question one - at George Mason University
Discuss how the rational expectations “revolution” has influenced the following theories: (Be sure to include in your discussion a rational expectations model relevant to each theory)

  1. Consumption theory
  2. Investment theory
  3. Long-run economic growth
  4. Inflation and price level determination

To what extent has this “revolution” improved our understanding of macroeconomic events?

AnswerEdit

Consumption theory:
The rational expectations revolution influenced consumption theory by enabling the incorporation of uncertainty into Friedman's model of the permanent income hypothesis through Robert Hall in 1978. Hall's famous result was that the permanent-income hypothesis implies that consumption follows a random walk. This extention of the hypothesis was only possible by assuming rational expectations under uncertainty.[1]


Hall

"The intuition for this result is straightforward: if consumption is expected to change, the individual can do a better job of smoothing consumption. Suppose, for example, that consumption is expected to rise. This measn that the current marginal utility of consumption is greater than the expected future marginal utility of consumption, and thus that the individual is better off raising current consumption. Thus the individual adjusts his or her current consumption to the point where consumption is not expected to change."[2]



Investment theory:
Rational expectations is part of the foundation for CAPM, where the expected return of an asset equals the risk free rate of interest plus beta times the expected market movements minus that risk free rate.

E(r_i) = r_f + \beta_{im}(E(r_m) - r_f).\,

Bayesian updating and an average error or zero results in a market portfolio where only the asset's sensitivity to market fluctuations matter.

Long run economic growth:
I'm unsure about if this works for this category but rational expectations allow for the efficient market hypothesis, ensuring that markets work perfectly well (and in practice, near perfectly well) in the long run. Systematic problems don't happen, ensuring long run economic growth.



Inflation and price level determination:
The Lucas Island model was the first model to explain fluctuations in output without relying on money illusion. Lucas based his model on rational expectations under uncertainty.[3]
Improving Understanding The Lucas critique essentially pointed out that all individuals have rational expectations, that is, they update their expectations, and thus their behavior, with new information. The Lucas critique shattered many old macro-economic theories, such as the Phillips Curve, and forced macroeconomists to develop microfoundations in their models.

References

  1. Romer, David, "Advanced Macroeconomics", McGraw-Hill 2006, 3rd Edition, P.354
  2. Snowdon, Brian, "Modern Macroeconomics", Cheltenham 2005
  3. Lucas, Robert, "Expectations and the Neutrality of Money", Journal of Economic Theory, April 1973

Other QuestionsEdit

This macro-stub needs improving.

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