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| The Keynesian model of, say, 1965, didn't pay too much attention to expectations: they were assumed to be static and exogenous. In 1968, Friedman and Phelps pointed out just how misleading it can be to have such a cavalier attitude to expectations. They applied a particular model of expectations formation, adaptive expectations, to macroeconomics. It looked empirically to be pretty successful. |
| But adaptive expectations is theoretically unsatisfying. When there is a change in the economic environment, the theory of adaptive expectations implies that people will make systematic and predictable mistakes. If you can forecast your mistakes, surely you can also correct them. |
| Beginning in 1972 with work by Robert Lucas, macroeconomics moved toward a different way of modeling expectations, using the concept of rational expectations (RE). The basic principle of RE is that, if we assume that firms optimize over input choices, and consumers optimize over consumption choices, it is methodologically consistent to assume also that individuals optimize over their use of information. The practical implication of this is that a model of RE assumes that any mistakes that are made are unpredictable: they are random. |
| From such a simple idea, RE revolutionized the way researchers thought about macroeconomics. On the practical side it required new mathematics tools, and forced researchers to write down much more carefully-crafted mathematical models of the economy. But RE also had profound implications in terms of the predictions it made about behavior and policy. |
| In this section, we look at some of these profound implications. We will look at three, out of many possible, applications of RE to macroeconomic issues that were hitting the presses in the mid-1970s. The ones we look at have had a particularly deep impact on the profession, because they undermined the traditional Keynesian cases for active fiscal and monetary management of the economy. Collectively, these applications embody an approach to the economy that has been termed the new classical macroeconomics. We also look at the Keynesian response to the new classicals. |
| Download lecture notes for this section here. |
| Review questions for this section can be found here. |
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