Rational Expectations: the Challenge to Policy

The significant impact that rational expectations models have made on economics in the last ten years is due principally to one result: namely, that aggregate demand management designed to lower unemployment will always be ineffective. In the previous chapter we discussed the conceptual background to demand — management policy. We showed how the government could alter the level of employment prevailing in the economy by manipulating the level of aggregate demand through its command of monetary and fiscal policy. However, we noted that if prices and wages were completely flexible, any departure from the natural level of employment was bound to be temporary. But rational expectations theorists go much further. They argue that such policy is ineffective even in the short run — ‘an accurate understanding of how expectations are formed leads to the conclusion that short-run stabilisation policies are untenable’ (McCallum, 1980). In other words, the government cannot systematically alter the level of employment, even in the short run, through monetary and fiscal policy. This is known as the policy impotence result of rational expectations.