John F. Muth – Indiana University, early sixties.

1. Explain the following statement:  “The influences between expectations and outcomes flow both ways… Thus, there is a continual feedback from past outcomes to current expectations."

Outcomes depend partly upon what people expect to happen.

 People adjust their forecasts to the recent past.  So recent outcomes effect expectations and expectations will affect outcomes.

 People expect stock prices to be what they have been in recent past, and these expectations then affect stock prices because they affect what people do now.

2. What information assumption (regarding the public) do the rational expectations economists make and how does that impact government policy effectiveness in general?  How do random shocks fit into this theory?

Assume that people use all available and relevant information when making decisions.

Because of this, they know the “model” of the economy – how government policy will change variables.  So if they know, for example, that the government is going to increase the money supply, they expect it before it happens and ask for wage increases beforehand, negating any short run policy stimulus.

Only random shocks will have an impact.  Meaning only random shocks will fool people.

3. Why do the rational expectations economists assert that outcomes do not differ systematically (i.e. regularly or predictably) from what people expected them to be?

Can’t fool all of the people all of the time.  All it takes is enough people to have correct expectations and the outcome will reflect these expectations.  Although some people can make a mistake, but errors will not persistently occur on one side or the other.  People learn from the past.

4. What do rational expectations economists assume about how people behave?

People behave in a way that maximizes their utility or profits.

5. What is meant by the idea that “efficient markets theory of stock prices” and how do rational expectations fit into the theory?

Efficient market theory – all available, relevant information is used in predicting the stock market.

If the current value gives the best possible prediction of future values – stock prices will follow a random walk.  When properly adjusted for discounting and dividends, stock prices follow a random walk.

Chain of reasoning:  in their efforts to forecast prices, investors comb all sources of information, including patterns that they can spot in past price movements.

Investors buy stocks that they expect to have a higher than average return and sell those that they expect to have lower returns.  When they do so, they bid up the prices of stocks expected to have higher than average returns (returns decrease) and drive down the prices of those expected to have lower than average returns (returns increase).

The prices of stocks adjust until the expected returns, adjusted for risk, are equal for all stocks.

The only factors that can affect stock prices are random factors that could not be known in advance.

6. What is meant by the idea of the “permanent income theory of consumption: and how do rational expectations fit into the theory (at least implicitly)?  How does Milton Friedman define “wealth?”  What does “consumption smoothing” mean?

Consumption depends not just on current income but also on prospects of income in the future.

People consume out of their “permanent income,” which can be defined as the level of consumption that can be sustained while leaving wealth in tact.

Wealth (as defined by M. Friedman) – the present value of people’s expectations of future labor income.

Rational expectations again will conclude that consumption is a random walk – the best prediction of future income is current income.  Consumption will only change with a random shock to income (like getting fired, which is not in the rational expectations of the individual).

Consumption Smoothing:  People estimate wealth and then allocate it over time.  They smooth out their consumption to make their wealth last.

Again, with temporary tax cuts, people will simply assume the taxes will go up later and not change their consumption – not much effect.

7. What is meant by the idea of “tax smoothing” and how do rational expectations fit into the theory?  How does it “minimize the supply disincentives” (cumulative distorting effects) associated with taxes?

People make decisions partly in response to the government’s plans for setting taxes in the future.

 The government should finance volatile (unsmooth) spending with stable (smooth) tar rates over time.

Workers who pay 20 percent marginal tax rate every year will reduce their labor supply less (will work more at any given wage) than they would if the government set a 10 percent marginal tax rate in half the years and a 30 percent in the other half.

Workers won’t change their current supply of labor due to future changes in taxes.

During and after a war the government raises taxes – the cost of the war is spread out over time.

8. How are business cycles (such as the Philips curve theory) based on errors in people’s forecasts?

People (workers) don’t expect the price levels to increase, so they don’t ask for cost of living raises.  Prices go up, they are fooled for a while.

9. What is the “Policy Ineffectiveness Proposition?”

If expectations are rational, it simply is not possible for the government to manipulate those forecast errors in a predictable and reliable way for the very reason that the errors made by a rational forecaster are inherently unpredictable.

ERRORS ARE RANDOM.

Policies that try to manipulate the economy by inducing people into having false expectations may introduce more “noise” into the economy but cannot, on average, improve the economy’s performance.

10. Does the “policy ineffectiveness” result apply to all government policy?  Why or why not?

No, only those that try to fool people or induce errors.

Those policies that effect margins or incentives will have an effect.

So the rational expectations guys try to determine the “optimal” policy, given people have rational expectations but will respond to incentive changes.