Foundations of Modern Macroeconomics: Chapter 3
1
Foundations of Modern Macroeconomics B. J. Heijdra & F. van der Ploeg
Chapter 3: Rational Expectations and Economic Policy
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Aims of this lecture
The aims of this lecture are the following:
• What do we mean by the Rational Expectations Hypothesis [REH]
• What are the implications of the REH for the conduct of economic policy? The “PolicyIneffectiveness Proposition” [PIP]
• What are the implications of the REH for economic modelling? The “Lucas critique”
• What is “real” and what is “gimmick” about the way the REH was sold to the economics profession?
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Reminder
• Recall how policy works in a neoclassical synthesis model with AEH
Y 
= 
Y 
= 
˙ 
AD(G _{+} , M/P ),
+
Y ^{∗} + φ [P − P ^{e} ] ,
AD _{G} > 0, AD _{M}_{/}_{P} > 0
φ > 0,
P ^{e} = λ [P − P ^{e} ] , λ > 0.
• initially in full equilibrium in point E _{0} (Y = Y ^{∗} , P = P _{0} = P
0
e ) [see Figure 3.1]
– increase in the money supply shifts the AD curve out
– initial effect: move from E _{0} to point A.
– in point A: expectations falsiﬁed (P ^{}
– gradually over time the economy moves back to the new full equilibrium in E _{1}
= P _{0} = P
e
0
)
(where Y = Y ^{∗} , P = P _{1} = P
1
e )
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Observation
• Odd adjustment path under the AEH: economics is based on the assumption of rational agents.
• But, as Figure 3.2 shows, under the AEH agents make systematic mistakes along the entire adjustment path.
• In the present case all errors are negative, i.e. there is systematic underestimation of the price level (P ^{e} < P ) during the adjustment period.
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Figure 3.2: Expectational Errors Under Adaptive Expectations
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Reaction
• This prompted John Muth to postulate the REH
• Rational agents do not waste scarce resources (of which information is one)!
• REH in words: subjective expectation (P
t
e ) coincides with the objective expectation
conditional on the information set of the agent.
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Simple example of a market for some agricultural good
• Assume that the market for this good is captured by the following equations:
Q
D
t
S
Q _{t}
Q
D
t
= a _{0} − a _{1} P _{t} , a _{1} > 0,
= b _{0} + b _{1} P _{t} + U _{t} , b _{1} > 0,
=
e
Q
S
t
[≡ Q _{t} ] ,
– demand depends on actual price in current period
– supply depends on expectation regarding the current price [takes time to raise a pig!]
– supply is subject to stochastic shocks, U _{t} [weather, swine fever]
– the market clears and demand equals supply
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• information set available when the supply decision is made (period t − 1) is denoted by Ω _{t}_{−}_{1} :
Ω t−1 ≡ ^{}
P _{t}_{−}_{1} , P _{t}_{−}_{2} ,
; Q _{t}_{−}_{1} , Q _{t}_{−}_{2} ,
; a _{0} , a _{1} , b _{0} , b _{1} ; U _{t} ∼ N (0, σ ^{2} )
(a)
(b)
(c)
(a) 
agents do not forget (relevant) past information 
(b) 
agents know the parameters of the model 
(c) 
agents know the stochastic process of the shocks [e.g. the normal distribution, as is drawn in Figure 3.3. Can be any distribution.] 
• REH in mathematical form: P
e
t
= E [P _{t}  Ω _{t}_{−}_{1} ] ≡ E _{t}_{−}_{1} P _{t} , where we use the
shorthand notation E _{t}_{−}_{1} to indicate that the expectation is conditional upon information set Ω _{t}_{−}_{1}
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U t
Figure 3.3: The Normal Distribution
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How do we solve this model?
• Executive summary : solve the model for its market equilibrium, take expectations,
and think, think
! The recipe:
• Demand equals supply equals quantity traded:
e
Q _{t} = a _{0} − a _{1} P _{t} = b _{0} + b _{1} P + U _{t}
t
_{P} _{t}
_{=}
a _{0} − b _{0} − b _{1} P
t
e − U _{t}
a 1
=⇒
(#)
• Take expectations based on the information set Ω _{t}_{−}_{1} :
E t−1 P t = E t−1 ^{a} ^{0} ^{−} ^{b} ^{0} ^{−} ^{b} ^{1} ^{P}
a
1
t
e − U _{t}
_{=}
−
b
1
1
a
(b)
(a)
(a)
(a)
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(a)
(b) expectation of a constant equals that constant, i.e. E _{t}_{−}_{1} P
take out of expectations operator because a _{0} , a _{1} , b _{0} , and b _{1} are in Ω _{t}_{−}_{1}
e
t
= P
e
t
(c)
as U _{t} ∼ N (0, σ ^{2} ) there is no better prediction than E _{t}_{−}_{1} U _{t} = 0
• We are left with:
E t−1 P t
_{=}
(a)
^{} a _{0} − b _{0}
a
1
−
a 1
b 1
e
P
t
(b)
(*)
According to the REH, the objective expectation of the price level [(a) on the lefthand side] must be equal to the subjective expectation by the agents [(b) on the
righthand side]. Hence, (*) can be solved for P
e
t
:
e a _{0} − b _{0}
t
_{=}
a 1
P
^{−}
b
1 ^{P}
1
e
t
a
P ^{e}
t
=
E t−1 P t = ^{a} a ^{0} _{1} ^{−} + b ^{b} _{1} ^{0}
⇒
(**)
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**** Self test ****
In Chapter 1 we argued that the perfect foresight hypothesis [PFH] is the deterministic counterpart to the REH. Can you see how our agricultural model would be solved under PFH? Show that you will arrive at (**)?
****
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• What does the actual market clearing price level look like? Substitute P quasi reduced form equation for P _{t} (see (#))
t
e in the
¯
P _{t}
=
_{=}
=
^{1} 1 a _{0} − b _{0} − b _{1} ^{a} ^{0} ^{−} ^{b} ^{0} − U _{t}
a
a _{1} + b _{1}
^{} a _{0} − b _{0} a _{1} + b _{1}
P −
¯
1
a
1
−
U _{t} ,
1 ^{U} ^{t}
1
a
where P is the equilibrium price that would obtain if there were no stochastic elements in the market [here is the answer to the self test].
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• The actual market clearing price is stochastic but the best prediction of it [the rational expectation for P _{t} ] is the deterministic equilibrium price in this case.
– See Figure 3.4 for a computergenerated illustration. Computer generates time series of (quasi) random numbers.
– In Figure 3.5 we illustrate how actual and expected price would ﬂuctuate under the AEH.
**** Self test ****
What would happen to P
e and P _{t} if the supply shock, U _{t} , is autocorrelated, e.g.
t
U _{t} = ρ _{U} U _{t}_{−}_{1} + ε _{t} with ρ _{U}  < 1 and ε _{t} ∼ N (0, σ
2 ε )?
****
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Figure 3.4: Actual and Expected Price Under Rational Expectations
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Figure 3.5: Actual and Expected Price Under Adaptive Expectations
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Applications of the REH to macroeconomics
• New Classical economists like Lucas, Sargent, Wallace, and Barro introduced the REH into macroeconomics
• Simple ISLMAS model with rational expectations:
y _{t} = α _{0} + α _{1} (p _{t} − E _{t}_{−}_{1} p _{t} ) + u _{t}
y _{t} = β _{0} + β _{1} (m _{t} − p _{t} ) + β _{2} E _{t}_{−}_{1} (p _{t}_{+}_{1} − p _{t} ) + v _{t}
m _{t} = µ _{0} + µ _{1} m _{t}_{−}_{1} + µ _{2} y _{t}_{−}_{1} + e _{t}
(AS)
(AD)
(MSR)
– all variables are in logarithms, e.g. y _{t} ≡ ln Y _{t} etcetera
– AS is the aggregate supply curve, α _{1} > 0, and u _{t} ∼ N (0, σ _{u} ) is the stochastic shock hitting aggregate supply
– AD is the aggregate demand curve, β _{1} , β _{2} > 0, and v _{t} ∼ N (0, σ _{v} ) is the stochastic shock hitting aggregate demand
2
2
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– used approximation ln(P _{t}_{+}_{1} /P _{t} ) ≈ (P _{t}_{+}_{1} /P _{t} ) − 1
– expected inﬂation, E _{t}_{−}_{1} (p _{t}_{+}_{1} − p _{t} ), enters the AD curve because money demand (and thus the LM curve) depends on the nominal interest rate whilst investment demand (and thus the IS curve) depends on the real interest rate. [“Tobin effect”]
– MSR is the money supply rule, and e _{t} ∼ N (0, σ
2
e
) is the stochastic shock in the
rule [impossible to perfectly control the money supply]
– both u _{t} and v _{t} are not autocorrelated
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Two key tasks:
• What is the rational expectation solution of the model. The variable of most interest, from a stabilization point of view, is (the logarithm of) aggregate output, y _{t}
• Can the policy maker stabilize the economy by choosing the parameters of the money supply rule appropriately? [Leaving aside the question whether it should do so]
Solution of this model proceeds as follows:
• Use AD and AS to solve for the price level:
α _{0} + α _{1} (p _{t} − E _{t}_{−}_{1} p _{t} ) + u _{t} = β _{0} + β _{1} (m _{t} − p _{t} ) + β _{2} E _{t}_{−}_{1} (p _{t}_{+}_{1} − p _{t} ) + v _{t}
or:
_{p} t _{=} β _{0} − α _{0} + β _{1} m _{t} + α _{1} E _{t}_{−}_{1} p _{t} + β _{2} E _{t}_{−}_{1} [p _{t}_{+}_{1} − p _{t} ] + v _{t} − u _{t} α _{1} + β _{1}
(*)
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• Take expectations based on information set dated t − 1 [this is not just a lucky guess–observe that we need the price error, p _{t} − E _{t}_{−}_{1} p _{t} , in the AS curve]
_{E} t−1 _{p} t _{=} _{E} t−1 ^{} β _{0} − α _{0} + β _{1} m _{t} + α _{1} E _{t}_{−}_{1} p _{t} + β _{2} E _{t}_{−}_{1} [p _{t}_{+}_{1} − p _{t} ] + v _{t} − u _{t} α _{1} + β _{1}
– parameters are known by the agents and can be taken out of the expectations operator
– E _{t}_{−}_{1} E _{t}_{−}_{1} p _{t} = E _{t}_{−}_{1} p _{t} and E _{t}_{−}_{1} E _{t}_{−}_{1} p _{t}_{+}_{1} = E _{t}_{−}_{1} p _{t}_{+}_{1} (the expectation of a
constant is that constant itself)
– E _{t}_{−}_{1} v _{t} = 0 and E _{t}_{−}_{1} u _{t} = 0 by assumption (no autocorrelation in the shocks)
• Imposing all these results we ﬁnd:
E t−1 p t = β _{0} − α _{0} + β _{1} E _{t}_{−}_{1} m _{t} + α _{1} E _{t}_{−}_{1} p _{t} + β _{2} E _{t}_{−}_{1} [p _{t}_{+}_{1} − p _{t} ]
α _{1} + β _{1}
(**)
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• By deducting (**) from (*) we ﬁnd an expression for the price error:
p t − E t−1 p t =
β 1
_{β} 1 [m _{t} − E _{t}_{−}_{1} m _{t} ] + _{α} 1 _{+} _{β} 1 [v _{t} − u _{t} ]
1
α _{1} +
The price is higher than rationally expected if:
(#)
– the money supply is higher than was rationally expected (m _{t} > E _{t}_{−}_{1} m _{t} )
– the AD shock was higher than was rationally expected (v _{t} > E _{t}_{−}_{1} v _{t} = 0)
– the AS shock was lower than was rationally expected (u _{t} < E _{t}_{−}_{1} u _{t} = 0)
• By using the MSR agents rationally forecast the money supply in period t:
E t−1 m t = µ _{0} + µ _{1} E t−1 m t−1 + µ _{2} E t−1 y t−1 + E t−1 e t
= µ _{0} + µ _{1} m _{t}_{−}_{1} + µ _{2} y _{t}_{−}_{1}
• Hence, the “money surprise” is:
m _{t} − E _{t}_{−}_{1} m _{t} = e _{t}
($)
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• By substituting (#) and ($) into the AS curve we obtain the REH solution for output:
_{y} t _{=} _{α} 0 _{+} α _{1} β _{1} e _{t} + α _{1} v _{t} + β _{1} u _{t} α _{1} + β _{1}
• We have derived a “disturbing result”: output does not depend on any of the policy variables (the µ _{i} coefﬁcients)! Hence, the policy maker cannot inﬂuence output in this model! This is the strong policy ineffectiveness proposition [PIP]
• A corollary of this proposition is the socalled Lucas critique: the macroeconometric models used in the 1960 and 1970s are no good for policy simulation because their coefﬁcients are not invariant with respect to the policy stance. Once you attempt to use the macroeconometric model for setting policy its parameters will change.
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Should the PIP be taken seriously?
• Subtitle: are macroeconomists useless?
• To disprove a supposedly general proposition all that is needed is one counterexample
• The Keynesian economist Stanley Fischer provided this counterexample
• Key idea: if there are nominal (nonindexed) wage contracts which are renewed less frequently than new information becomes available, the government has an informational advantage over the public
• Result: stabilization is possible [PIP invalid] and is desirable [raises welfare]
• In order to show that the informational advantage of the policy maker is crucial we ﬁrst study the case with oneperiod contracts. Then we go on to the general case with twoperiod contracts
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Model 1: Singleperiod nominal wage contracts
• All variables in logarithms
• The AD curve is monetarist [no Tobin effect and no effect of government consumption]:
y _{t} = m _{t} − p _{t} + v _{t}
(AD)
• AD shock is assumed to display autocorrelation:
v _{t}
η _{t}
=
∼
ρ _{V} v _{t}_{−}_{1} + η _{t} ,
N (0, σ
2
η )
ρ _{V}  < 1
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• The nominal wage is set in period t − 1 to hold for period t is such that full employment of labour is expected in period t. The equilibrium real wage rate is normalized to unity (so that its logarithm is zero):
w _{t} (t − 1 ) = E _{t}_{−}_{1} p _{t}
(a)
(a) date of contract settlement
(*)
• The supply of output depends on the actual real wage in period t [labour demand determines the quantity of labour traded and thus output]
y _{t} = − [w _{t} (t − 1) − p _{t} ] + u _{t}
• The shock in output supply is autocorrelated:
u
ε
_{t}
_{t}
= 
ρ _{U} u _{t}_{−}_{1} + ε _{t} , 

N (0, σ 
2 
) 

∼ 

ε 
ρ _{U}  < 1
(**)
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• Inserting (*) into (**) yields a kind of Lucas supply curve:
y _{t} = [p _{t} − E _{t}_{−}_{1} p _{t} ] + u _{t}
(LSC)
• The policy rule of the monetary policy maker is given by:
m _{t} =
∞
i=1
µ _{1}_{i} u t−i +
∞
i=1
µ _{2}_{i} v _{t}_{−}_{i}
(MSR)
– in principle policy maker can react to all past shocks in aggregate demand and supply
– in practice it is only needed to react to shocks lagged once and lagged twice, so
that µ _{1}_{i} = µ _{2}_{i} = 0 for i = 3, 4, · · · , ∞
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• Rational expectations solution for the price error is:
p t − E t−1 p t =
=
_{2} ^{} (m t − E t−1 m t
1
(a)
_{2} 1 [η _{t} − ε _{t} ]
) + (v _{t} − E _{t}_{−}_{1} v _{t} ) − (u _{t} − E _{t}_{−}_{1} u _{t} ) ^{}
(b)
(c)
(a) 
m _{t} − E _{t}_{−}_{1} m _{t} = 0 as the MSR only contains variables that are in the information set of the agent at time t − 1 
(b) 
v _{t} − E _{t}_{−}_{1} v _{t} = η _{t} as agents know the stochastic process for v _{t} 
(c) 
u _{t} − E _{t}_{−}_{1} u _{t} = ε _{t} as agents know the stochastic process for u _{t} 
• Rational expectations solution for output is:
y _{t} = ^{1} _{2} [η _{t} − _{t} ] + u _{t}
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• Conclusion: for model 1 we still have PIP. The policy parameters (µ _{1}_{i} and µ _{2}_{i} ) do not inﬂuence aggregate output at all despite the fact that there are nominal contracts. The reason is that the policy maker is as much in the dark as the private agents are and thus has no informational advantage
**** Self test ****
Make sure you understand how this model is solved under rational expectations. Work through the detailed derivation in the book
****
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Model 2: Twoperiod overlapping nominal wage contracts
• AD curve and MSR the same as before:
y _{t}
m _{t}
• Nominal wage contracts
– run for two periods
=
=
m _{t} − p _{t} + v _{t}
∞
µ _{1}_{i} u t−i +
i=1
∞
i=1
µ _{2}_{i} v _{t}_{−}_{i}
(AD)
(MSR)
– each period, half of the work force is up for renewal of their contract
– wage set such that market clearing of labour market is expected
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– in period t half of the work force receive w _{t} (t − 1) and the other half receives
w _{t} (t − 2):
w _{t} (t − 1)
w _{t} (t − 2)
≡
≡
E _{t}_{−}_{1} p _{t}
E _{t}_{−}_{2} p _{t}
– half of the work force is on wages based on “stale information” (i.e. dated t − 2)
• ﬁrms are perfectly competitive [law of one price]. Aggregate supply is:
y _{t} = ^{1} _{2} ^{} p _{t} − w _{t} (t − 1) + u _{t} ^{} + _{2} ^{} p _{t} − w _{t} (t − 2) + u _{t}
1
^{}
(a)
(b)
(*)
(a) 
supply by ﬁrms which renewed their workers’ contract in the previous period 
(b) 
supply by ﬁrms which renewed their workers’ contract two period ago 
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• By substituting w _{t} (t − 1) and w _{t} (t − 2) into (*) we obtain the AS curve when there are overlapping nominal wage contracts:
y _{t} =
_{2} 1 [p _{t} − E _{t}_{−}_{1} p _{t} ] + _{2} [p _{t} − E _{t}_{−}_{2} p _{t} ] + u _{t} .
1
• The rational expectations solution for output is:
y _{t}
=
_{2} 1 [η _{t} + _{t} ] + ρ ^{2}
_{U} u t−2
+ _{3} [µ _{2}_{1} + ρ _{V} ] η _{t}_{−}_{1} + _{3} [µ _{1}_{1} + 2ρ _{U} ] _{t}_{−}_{1} .
1
1
– ﬁrst line contains no policy parameters. This is unavoidable turbulence in the economy
– second line contains policy parameters (µ _{2}_{1} and µ _{1}_{1} ). The policy maker can offset the effects of η _{t}_{−}_{1} and ε _{t}_{−}_{1} by choosing µ _{2}_{1} = −ρ _{V} and µ _{1}_{1} = −2ρ _{U}
– PIP is refuted by this example as output can be stabilized
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• Stabilization is not only feasible, it is highly desirable as it improves economic welfare [as proxied by the asymptotic variance of output]:
2
σ _{Y}
(b)
(a) By setting µ _{1}_{1} = −2ρ _{U} this term can be eliminated. Intuition: if ε _{t}_{−}_{1} > 0 [positive innovation to the supply shock process] then the money supply should be reduced somewhat to avoid “overheating” of the economy [countercyclical monetary policy]
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(b) Similarly, by setting µ _{2}_{1} = −ρ _{V} this term can be eliminated. Intuition: if η _{t}_{−}_{1} > 0 [positive innovation to the demand shock process] then the money supply should be reduced somewhat to avoid “overheating” of the economy [countercyclical monetary policy]
• The government can improve matters (relative to nonintervention) because it has an informational advantage relative to the public (i.e. those workers and ﬁrms who are operating on contracts based on stale information)
**** Self test ****
Make sure you understand how we obtain the rational expectations solution for output and how we derive the expression for the asymptotic variance of output.
****
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Punchlines
• REH does not in and of itself imply PIP
• REH + Classical model ⇒ Classical conclusions
• REH + Keynesian model ⇒ Keynesian conclusions
• REH accepted by virtually all economists [extension if equilibrium idea to expectations]
• but we hope for more!!
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2
F Y
Figure 3.7: The Optimal Contract Length
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