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rehconsump - Rational Expectations And PIH/LCH Under REH...

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Rational Expectations Rational Expectations And PIH/LCH Under REH And PIH/LCH Under REH Macroeconomics I ECON 309 – Cunningham
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2 Muth: Rational Expectations Muth: Rational Expectations Muth, John F., “Rational Expectations and the Theory of Price Movements,” Econometrica, vol. 29 no. 3 (July 1961). “In order to fairly simply explain how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant theory.” “... the economy does not waste information . .. ” “What kind of information is used, and how it is put together to frame an estimate of future conditions is important to understand because the character of dynamic processes is typically very sensitive to the way expectations are influenced by the course of actual events.”
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3 More Muth More Muth Two major conclusions from studies of expectations data are: Averages of expectations in an industry are more accurate than naive models and as accurate as elaborate equation systems. .. Reported expectations generally underestimate the extent of changes that actually take place. To order to explain these phenomena, I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.
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4 More Muth More Muth More precisely, the expectations (the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes).
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5 Rational Expectations Rational Expectations 0 100 200 300 400 500 600 Tally 0 1 2 3 4 5 6 Predicted Inflation Rate Inflation Survey Subjective Objective
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6 More Muth More Muth Information is scarce, and the economic system generally does not waste it. The way expectations are formed depends specifically on the structure of relevant system describing the economy.
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7 Rational Expectations Hypothesis (REH) Rational Expectations Hypothesis (REH) Expectations are formed on the basis of all available relevant information concerning the variable being predicted. Agents understand the underlying economic relationships. As a result, expectational errors are NOT systematic.
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8 Adaptive vs. Rational Expectations Adaptive vs. Rational Expectations Adaptive Expectations Rational Expectations Actual Actual x x x x x x x x x x x x x x x x x
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9 Consumption Function Consumption Function Major Problem of Empirical Research: Fitting the part of the model that relates current and past observed income to expected future income.
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rehconsump - Rational Expectations And PIH/LCH Under REH...

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