Rationality

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A Child's Guide to Rational Expectations Author(s): Rodney Maddock and Michael Carter Reviewed work(s): Source: Journal of Economic Literature, Vol. 20, No. 1 (Mar., 1982), pp. 39-51 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2724658 . Accessed: 30/07/2012 13:35 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp

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Journal of Economic Literature Vol. XX (March 1982), pp. 39-51

A Child's Guide to Expectations Rational
By RODNEY MADDOCK AND MICHAEL CARTER Research School of Social Sciences Australian National University

DRAMATISPERSONAE

(In order of speaking) Ernie, first student, is something of a Keynesian. Bert, second student, is more inclined to monetarism. Scene i Scene ii Scene iii Appendix A Appendix B References Prologue The Idea of Rational Expectations Deriving the Impotence Results Criticisms Testing Significance Conclusion Aggregate Supply Algebra of the Model

Scene i. Prologue (Two students sharing coffee in the union of an Australian university.) Ernie: Did you read that ridiculous article in Challenge the other day? * Our thanks to Neville Cain for his inspiration for this paper and to our colleagues at ANU, notably Malcolm Gray, Adrian Pagan and Jim Trevithick, for their comments. We are also grateful to Fred Gruen and to an anonymousreferee and the editor for their assistance.All faults,of course, remain ours.

Bert: Which? Ernie: Somebody named Bennett McCallum was saying that rational expectations proved that the government could not stabilize the economy. Hang on, I've got it here: "An accurate understanding of how expectations are formed leads to the conclusion that short-run stabilization policies are untenable." (McCallum, 1980, p. 37). I don't know how they could develop theories like that. It's pretty obvious that government policy does affect the economy in the short run.

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Journal of Economic Literature, Vol. XX (March 1982)
all the people all the time. Therefore, systematic policy is ineffective.5 Ernie: I'm not at all sure that the long-run Phillips curve is vertical.6 We used to have about one percent unemployment; now we seem to be stuck at about eight percent. How can you explain that with a vertical Phillips curve. "The Phillips curve is vertical but moves around a lot"-hardly seems much of a theory.7 Even if it is vertical and we can't get away from it except by fooling people, clearly the government can fool people. Every time it changes policy the people don't know about the new policy for a while so it takes time before they catch up.8 Bert: But that's just what rational expectations is all about! It suggests that people anticipate the effects of the new policy. If that's true, then the policies won't cause any increase in employment! Ernie: How on earth are people supposed to anticipate the effects of policy? I just can't see it. Have they all got econometric models under the sink?9 Bert: (Angrily) Now you're just being silly. Have you read any of the basic literature-Lucas, Sargent, Wallace, and so on? Ernie: I've looked at some but it just seems unreal-too many equations. They never define exactly how they think anybody forms these "rational expectations." Bert: Look, I've got to go to my macro lecture. How about we meet again tomorrow, 5 This is Friedman's proposition that...
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