Rational Expectation Theory

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QUESTION: Given the 'Rational Expectations Theory' a short run tradeoff between the price level and unemployment can only exist if the economy agent can distinguish arbitrary from real shock. Discuss

Rational Expectations Theory

What is the 'Rational Expectations Theory'

The rational expectations theory is an economic idea that the people in the economy make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in the economy are equivalent to what the future state of the economy will be. This contrasts the idea that government policy influences the decisions of people in the economy.

BREAKING DOWN 'Rational Expectations Theory'

The idea is that rational expectations of the players in an economy will partially affect what happens to the economy in the future. If a company believes that the price for its product will be higher in the future, it will stop or slow production until the price rises. Because the company weakens supply while demand stays the same, price will increase. In sum, the producer believes that the price will rise in the future, makes a rational decision to slow production and this decision partially affects what happens in the future.
"Inflation-Unemployment Trade-off under Adaptive Expectation and under Rational Expectation"?
When agents in economy have adaptive expectations they predict future in the basis of what happened in the past. If we consider an inflation adjustment scenario, the expected inflation by the agents is directly dependent on the inflation that prevailed in the immediately previous period and the output gap.
Y = Yo + b(P - Pe) where Pe is expected price level
When agents have adaptive expectations there is an inflation inertia.
To reduce…...

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