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Question from Past Macroeconomics Qualifying Exam (Fall, 2005 - Question one) at George Mason UniversityEdit

Many economists argue that the notion of ‘Rational Expectations Theory’ has revolutionized macroeconomic theory. Briefly discuss how this notion has affected each of the following areas within macroeconomics. In each case, outline a simple model that uses the notion of ‘rational expectations’ as the basis for its main predictions:

  • a. Inflation theory
  • b. International capital flows
  • c. Labor markets
  • d. Consumption theory

AnswerEdit

  • a.Inflation bias and money neutrality: Since people are rational actors who learn from games we know that the federal reserve has a bias toward inflation (they seek to lower the unemployment in the current period because of current political pressures). These can even be the same preferences as the public. Since this is known inflation is set on a locus of tangencies between short run philips curves and preference sets for indflation and unemployment. The end result is a positive rate of inflation on the long-run phillips curve (i.e. the the natural rate of unemployment). Since this is a stable and predictable point and no additional policy "rent" is available, money becomes nuetral. [see Barro, Kydland, Prescott et al.]
  • b.Somne sort of PPP?
  • c. Efficiency wage (perhaps?)
  • d. Permenant Income Hypothesis: This assumes that the rational actor will not only spread out in come equally between all periods of consumption but also knows the actual numbers of periods of life.

Utility is a function of consumption

Maximizing utility is subject to the constraint of initial wealth and lifetime earnings.

divide consumption by the number of periods of life (this follows from diminishing utility, that the consumption should be equal across periods).

Other QuestionsEdit

This macro-stub needs improving.

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