ECON30611 - MACROECONOMICS III

RATIONAL EXPECTATIONS - INTRODUCTION

Paul Middleditch
Department of Economics
University of Manchester

September 23, 2014

Paul Middleditch

Department of Economics University of Manchester page 1 of 22

Introduction

Lecture Notes

My lecture notes can be found on Blackboard 9

ECON30611 Macroeconomics IIIA (Semester 1)
Office Hours

Arthur Lewis Building - Room 3.009

Wednesdays 10.30am - 12.30pm
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@PaulM Mac3A14

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Office hours are held during: 24th September to 10th

December 2014 (Sem. 1) and 27th January to 17th March
2015 & 21st April to 1st May 2015 (Sem. 2)
Paul Middleditch

Department of Economics University of Manchester page 2 of 22

Introduction

IMPORTANT:

The slides provided on Blackboard should be used as a

framework/outline to help you take detailed notes in the lectures and
should not be considered as definitive course material.
If you are unable to attend a lecture for any reason then you will be
able to take the material missed from the course readings provided.
The course readings will also supplement the material given in the
lectures for advanced completion of the course.
Employment Skill

Vocation Related Learning Outcome (VRLO):

To be able to understand and convey both verbally and

mathematically the fundamental driving forces behind real and
financial markets.

Paul Middleditch

Department of Economics University of Manchester page 3 of 22

Introduction

Paul Middleditch

Week
Week
Week
Week

1
2
3
4

Introduction to Rational Expectations

Solving Rational Expectations Models
Rational Expectations and Policy Neutrality
New Keynesian Economics and Policy Neutrality

George Chouliarakis

Week 5 Dynamic Inconsistency and Credibility in Monetary Policy

Week 6 Addressing the Inflation Bias Problem of Discretionary
Monetary Policy
Week 7 Addressing the Inflation Bias Problem of Discretionary
Monetary Policy II

Paul Middleditch

Department of Economics University of Manchester page 4 of 22

Introduction

What are Expectations?

Expectations are our calculated predictions of the future.

The expected value of a discrete r.v, x could be given by
E (x) = x1 P(x1 ) + x2 P(x2 ) + ....

(1)

the expected value of x is simply the sum of the possible values of x

times the individual probabilities of x taking that value.
So E (x)is the value that we expect x to take.

Paul Middleditch

Department of Economics University of Manchester page 5 of 22

Introduction

We form expectations before making decisions. Our decision making

process implicitly involves our expectation of the future.

Why are expectations important?

Often our prediction of the future turns out to be realised.

For example: If we expect prices to rise quickly in the future we may
want a higher pay rise. Higher wage bills lead to higher costs lead to
price increases, fulfilling our expectation.
mathematically xt+1 = Et (xt+1 ), or expectations are self fulfilling.

Paul Middleditch

Department of Economics University of Manchester page 6 of 22

Introduction

Expectations and Macro Models

Example: The fisher equation relates the nominal interest rate with
the change in the price level:
i =r +

(2)

If we assume that r is constant then, an increase in inflation

ultimately leads to higher nominal interest rates.
Encompassing Expectations

We can improve the ability of model to predict the fact by

encompassing expected rather than realised inflation in the model.
Agents base their investment/interest rate decisions not on inflation
but on expected inflation thus
i = r + E ()

(3)

Encompassing expectations leads to models that better describe the

stylized facts
Paul Middleditch

Department of Economics University of Manchester page 7 of 22

Introduction

Types of Expectations

There are two main types of expectation theory:

1. Adaptive Expectations: Agents base their expectations on the past

and a proportion of the forecast error from the previous period

Koyck (1954) Distributed lags and investment analysis and Cagan
(1956) The monetary dynamics of hyperinflation
2. Rational Expectations: Agents base their expectations given full

knowledge of the economic model and using all information past and
present.
Muth (1961) Rational expectations and the theory of price
movements
In this course we are mainly concerned with the expectation of

inflation t .
Paul Middleditch

Department of Economics University of Manchester page 8 of 22

Mathematical Notation

Definitions

t :

Actual inflation in period t.

t+1 :

Actual inflation in period t + 1.

te :

Subjective expectations for period t (Weak form RE).

Conditional Expectations

Et :
Et1 :

Conditional expectation formed in period t.

Conditional expectation formed in the previous period.

Et t+1 E (t+1 |It )

The rational expectation of future prices.

Iterating one period backward:

Et1 t E (t |It1 )
Explanation: the expectation of current inflation formed one period
ago is based on all available information up to that period.
Paul Middleditch

Department of Economics University of Manchester page 9 of 22

Mathematical Notation

Deriving a Simple Dynamic Equation

Imagine that inflation, t : could be described by a discounted stream

of expected future marginal cost.

We can manipulate the expression in t to introduce dynamics in this

endogenous variable.

j j Et mct+j

j=0

= mct +

j j Et mct+j

j=1

= mct +

X
j j
j=1

Et mct+j
(4)

Paul Middleditch

Department of Economics University of Manchesterpage 10 of 22

Mathematical Notation

Deriving a Simple Dynamic Equation

= mct +

j1 j1 Et mct+j

j=1

= mct +

j j Et mct+j+1

j=0

= mct + Et t+1

After this algebraic manipulation we have a dynamic equation in t ,

also known as the inflation equation or the Phillips curve

Paul Middleditch

Department of Economics University of Manchesterpage 11 of 22

Adaptive Expectations

Adaptive Expectations

Koyck (1954), Cagan (1956), Friedman (1968)The role of monetary

policy
In its simplest form:
Et1 t Et2 t1 = (t1 Et2 t1 )

(5)

where is the speed of expectations adjustment

alternatively we can write the above as
Et1 t = t1 + (1 )(Et2 t1 )
note the cases of 0
and 1

Paul Middleditch

(6)

Et1 t = Et2 t1 (Static expectations)

Et1 t = t1 (Myopic expectations)

Department of Economics University of Manchesterpage 12 of 22

Adaptive Expectations

Examples of Adaptive Expectations

The Cobweb Model

For a discussion on the cobweb model see Sheffrin (p.2 and 133)
The adaptive expectation augmented Phillips curve

t = te (ut u ) + t

where te = t1

Weaknesses of the adaptive expectations hypothesis (AEH)

Revisions of expectations based only on past information
It underestimates acceleration of variables such as inflation

Paul Middleditch

Department of Economics University of Manchesterpage 13 of 22

Rational Expectations

Rational Expectations (RE)

Developed by Muth (1960), advanced by Sargent (1973) and Lucas

(1972)
There are two types of RE: Weak and Strong Forms
Weak Form (RE)

Rational agents expectations are constrained to the point where the

expected marginal cost from acquiring information is equal to the
expected marginal benefit derived from it.
Weak RE is based on subjective expectations
In this course we use the strong form RE

Paul Middleditch

Department of Economics University of Manchesterpage 14 of 22

Rational Expectations

Strong Form RE

Muth (1961) expectations, since they are informed predictions of

future events, are essentially the same as the predictions of the
relevant economic theory
Assumption: Subject to all available information, peoples subjective
probability distribution about future events is the same as that of the
actual probability distribution of these future events.
Assumption: Each rational agent is assumed to make full use of an
information set that includes all equations, variables, observations and
probability distributions of stochastic terms that describe the
economic system.
So under REH:

te = Et1 t E (t |It1 )

In other words subjective expectations = conditional

expectations
Paul Middleditch

Department of Economics University of Manchesterpage 15 of 22

Rational Expectations

Examples of using RE
If the process of inflation is given by:

t = t1 + t

(7)

then inflation follows a random walk, in which case t can be

considered white noise, ie t N(0, 2 )
Take conditional expectations at t-1
Et1 t = E (t1 + t |It1 )
as t1 is exogenous E (t1 ) = t1

and

Et1 t = t1

Paul Middleditch

(8)

E (t |It1 ) = 0
(9)

Department of Economics University of Manchesterpage 16 of 22

Rational Expectations

Properties of Rational Expectations

The Unbiasedness Property

The expected value of the forecast error, t = t+1 E (t+1 |It+1 ), is

zero
The Efficiency Property

The forecast error has the smallest possible variance of all possible
predictors.
The Lack of Serial Correlation Property

The expectations error is uncorrelated with past errors,

Cov (t+1 , t+1i |It+1i ) = 0

Paul Middleditch

Department of Economics University of Manchesterpage 17 of 22

AE vs RE: An Example

AE vs RE: An Example
In period t1 : t1 = 2%. Then in period t : there is an unanticipated
increase in by 1% that is unique and permanent (t+i = 3%)
How long will it take for inflation forecast error to be eliminated under RE
and AE?
Under Rational Expectations (Using (6))

Period t : t = 3%
E (t |It1 ) = E (t1 + t |It1 ) = t1 = 2%
The forecast error :t E (t |It1 ) = 1%
Period t + 1 : t+1 = 3%
Et t+1 = E (t+1 |It ) = E (t + t+1 |It ) = t = 3%
The forecast error : t+1 E (t+1 |It ) = 0%
Paul Middleditch

Department of Economics University of Manchesterpage 18 of 22

AE vs RE: An Example

Under Adaptive Expectations (Using(5))

Period t : t = 3%
Et1 t = t1 + (1 )(Et2 t1 ) = 2%
The forecast error :t E (t |It1 ) = 1%
Period t + 1 : t+1 = 3%
Et t+1 = t + (1 )(Et1 t ) = (3) + (1 )(2) = (2 + )%
The forecast error : t+1 E (t+1 |It ) = 3 (2 + ) = (1 )%
Period t + 2 : t+2 = 3%
Et+1 t+2 = t+1 + (1 )(Et t+1 ) = (3) + (1 )(2 + ) =
2 + (2 )%
The forecast error :
t+2 E (t+2 |It+1 ) = 3 [2 + (2 )] = (1 )2 %
No prizes for deriving the nth case, but we can see that as n
the forecast error diminishes towards zero.
Paul Middleditch

Department of Economics University of Manchesterpage 19 of 22

AE vs RE: An Example

Paul Middleditch

Department of Economics University of Manchesterpage 20 of 22

Summary

Rational Expectations vs Adaptive Expectations

Rational Expectations

Assumes that all people are equally smart and that economists make
on average accurate forecasts
In abscence of uncertainty (t = 0) RE converges to the case of
perfect foresight. The forecast error is always zero.
Empirical evidence shows that learning by people does not always
imply that peoples expectations will converge in the way postulated
by Muth.

Paul Middleditch

Department of Economics University of Manchesterpage 21 of 22

Summary

Rational Expectations vs Adaptive Expectations

Adaptive Expectations

AE assumes that peoples behaviour is strictly correlated to the past

and that they will make systematic mistakes in their predictions of the
future.
This backward looking hypothesis can not encompass the current
periods policy announcements or supply shocks. it is assumed that
people will ignore these.
The AE adjustment of expectations is sluggish and for large changes
in or accelerating inflation will produce increasing forecast errors.

Paul Middleditch

Department of Economics University of Manchesterpage 22 of 22