New Classical economics is based on the controversial
theory of rational expectations.
This theory was developed by Nobel laureate Robert Lucas of The University
of Chicago along with Thomas Sargent of Stanford and Robert Barrow of Harvard.
It provides a sharp contrast to the notion of adaptive
expectations we previously introduced in our lesson on inflation and unemployment.
You may recall from that lesson with Adaptive Expectations
people tend to assume that inflation will continue to be what it already is.
For example, if inflation was 3% last year Adaptive Expectations will
lead you to predict that inflation will be 3% next year.
In contrast, if you form your expectations rationally you will take into account
all available information including the future effects of activist fiscal and
monetary policies.
The idea behind rational expectations is that such activist
policies might be able to fool people for a while.
However, after a while, people will learn from their
experiences, and then you can't fool them at all.
The central policy implication of this idea is, of course, profound.
Rational expectations render activist
fiscal and monetary policies completely ineffective.
So, they should be abandoned.
And let me show you waht I mean.
Suppose the federal reserve undertakes expansionary monetary policy to close a
recessionary gap. Repeated experiences with such activist
policy have taught people that increases in the money supply fuel inflation.
To protect themselves
in a world of rational expectations, businesses will
immediately respond to the Fed's expansion by raising prices.
Workers will demand higher wages and the attempted stimulus
will be completely offset by the contractionary effects of inflation.