320.326: Monetary Economics Lecture 4 Instructor: Prof Robert Hill Rational Expectations

1. 320.326: Monetary EconomicsLecture 4 Instructor: Prof Robert HillRational Expectations Mishkin – Chapters 7, 22 and 25 1 1

2. 1. Rational Expectations Expectations are rational if they are optimal forecasts using all available information. Example: πte = πt + εt where πte = the expected rate of inflation in period t πt = the actual rate of inflation in period t εt = a random error term with mean zero (i.e., εte = 0) Until the 1970s, expectations in economic models were usually assumed to be adaptive. Adaptive expectations are based only on past experience (i.e., they are backward looking). The simplest case of adaptive expectations is where πte = πt-1 2 2

3. Adaptive expectations work well as long as fluctuations in the variable in question are reasonably random. To illustrate the problem with adaptive expectations, consider the following example: Suppose πt-1 = 10, πt-2 = 9, πt-3 = 8, πt-4 = 7, πt-5 = 6, πt-6 = 5, etc. According to adaptive expectations, πte = 10. Clearly, πte = 11 would be a better guess. Also, adaptive expectations ignore any new information. For example, suppose the central bank has just announced that it is about to implement a contractionary monetary policy, to try and reduce inflation. Adaptive expectations would ignore this information. The response of rational expectations would depend on the perceived credibility of the central bank. 3

4. When modelling how markets will respond to a change in government policy, it is more plausible to assume that agents are rational than that they make systematic mistakes (e.g., as can happen with adaptive expectations). Predictions based on adaptive expectations may generate misleading results. This proposition is known as the Lucas critique. Note: Ben Friedman argues that the assumption of rational expectations is not realistic in that it assumes market participants are better informed than they really are. He argues that if it was renamed “super-smart-agents expectations” then it would not be used so much in economic modelling. 4 4

5. An alternative is to assume some form of bounded rationality. For example, some models assume that some share of market participants (say θ) form their expectations rationally, while the remainder (1-θ) have adaptive expectations. The latter group form their expectations adaptively since they find it too costly to gather and process all the information necessary to form rational expectations. An interesting question then is how large must θ be for the market to behave as though everyone had rational expectations?

6. 2. The Efficient Markets Hypothesis (EMH) If market participants have rational expectations, then the efficient markets hypothesis (EMH) should hold. There are a number of different although related definitions of the EMH. Some are stronger than others. Here we focus on Malkiel’s definition. EMH states that there are no unexploited riskless arbitrage opportunities in the market. (Malkiel’s definition) An implication of EMH is that it is not possible to systematically outperform the market portfolio in risk-adjusted terms. Note: it is consistent with EMH that higher risk investment strategies on average yield a higher return. 6 6

7. Evidence in favour of EMH • Performance of investment analysts and mutual funds • EMH implies that the performance of mutual funds in the current period will be independent of their performance in past periods. • The empirical evidence mostly supports this conclusion. • Good performance by a fund in a particular period can typically be attributed to either luck, or following a higher risk strategy in good times, or a lower risk strategy in bad times. 7

8. (ii) Random walk behaviour of stock prices Empirical studies have confirmed that in general it is not possible to predict stock prices from past data. Even the inclusion of publicly available information (e.g., money supply growth, government spending, interest rates, corporate profits) does not change this result. That is, future movements in stock prices are unpredictable (in the absence of private information). Stock prices will respond to announcements only if the information is new and unexpected.

9. Evidence against the EMH • Market anomalies A number of anomalies have been found in the behavioural finance literature. Here we consider just one of these anomalies. The small firm effect Small firms on average tend to outperform larger firms. (Note: small firms are less liquid and hence more risky). This anomaly seems to indicate a violation of EMH. However, believers in the EMH explain away all anomalies (including this one) saying that they are due to differences in risk, and that once the correct risk adjustment is made the anomaly disappears. 9 9

10. (ii) Asset market bubbles A bubble is a situation where the price of an asset rises to a level that can only be justified by expectations of future capital gains, and not by the underlying stream of returns the asset is able to provide. A bubble does not necessarily imply a departure from EMH. If you think everyone else expects the price to keep rising, then maybe you should too. If everyone expects the price to rise it probably will. In Jan 2013 Eugene Fama (a true believer in EMH) was asked the following question: Many people would argue that … the inefficiency [in the GFC] was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.

11. Fama’s reply is illuminating. “I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” Part of the credit driven bubble argument is that lots of money was invested in the US by China and oil rich countries. The stable macroeconomic environment then encouraged banks to underestimate the risk of lending. Robert Shiller on the other hand has described EMH as “the most remarkable error in the history of economic thought.” Fama and Shiller (along with Hansen) shared the 2013 Nobel prize in economics for their work on asset pricing.

12. Another Nobel prize winner (Paul Krugman) said the following: “The belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a role in inflating that bubble in the first place.” Malkiel (another believer in EMH) denies that the housing bubble in the US was a violation of EMH. He says: “Markets can make mistakes, sometimes egregious ones, and those mistakes can have extremely unfortunate macroeconomic consequences. But there were no ex ante arbitrage opportunities.” If you think there is a bubble, you can bet against it by shorting the market. But the problem is you do not know when the bubble will burst.

13. Markets can remain irrational much longer than you can remain solvent betting against the market. (This quote is attributed to Keynes.) In other words, betting against a bubble is risky (even if you are certain it is a bubble). But arbitrage opportunites are hardly ever completely riskless. Even George Soro’s arbitrage on the British pound in 1992 was not 100 percent riskless. Malkiel’s definition of EMH makes it very hard to observe a clearcut violation of EMH, undermining the usefulness of the concept. Irrespective of what Malkiel thinks, many market participants believed in EMH and also believed that EMH implies that markets do not make mistakes. The GFC clearly demonstrated the folly of this belief.

14. 3. Aggregate Demand (AD)-Aggregate Supply (AS) Analysis The AD curve describes how aggregate demand (C+I+G+X-M) in real terms responds to changes in the price level. The AD curve can be derived from the ISLM model. An increase in the price level, other things equal, reduces the real money supply. This shifts the LM curve to the left, thus reducing real output. That is, a rise in P reduces Y. Hence the AD curve is downward sloping. See Figure 7.3 from Blanchard. 14 14

15. 15

16. The AD curve shifts to the right (see Blanchard Figure 4) when • The money supply rises (since this causes the interest rate i to fall, • thus causing I and X to rise and M to fall) • (ii) Government expenditure rises (G rises) • (iii) Taxes fall (T falls) • (iv) Net exports rise (X-M goes up) • (v) Consumer optimism rises (c0 and hence C goes up) • (vi) Business optimism rises (I goes up) • We distinguish between a short run aggregate supply curve (AS) and a long run aggregate supply curve (LRAS). • The LRAS curve is vertical and cuts the Y axis at the natural rate of output Yn. • The AS curve is upward sloping because higher output prices imply higher real profits in the short run (under the assumption that factor input prices are fixed in the short-run). The AS curve also assumes a given expected output price level. 16 16

17. 17

18. The AS curve shifts when • wages rise (as happens when Y > Yn) – leftward shift • (ii) there is a rise in the price of non-labour inputs (e.g., the price of oil goes up) – leftward shift • (iii) an increase in productivity – rightward shift • (iv) the expected price level rises – leftward shift • See Mishkin, Chapter 22, Figure 3. • A short-run equilibrium occurs at the intersection of the AD and AS curves. • If this short-run equilibrium lies to the right of the LRAS curve, then there will be upward pressure on wages and the prices of other factor inputs. This will cause the AS curve to shift to the left, until the economy ends up back on the LRAS curve. • The process of adjustment is shown in Mishkin, Chapter 22, Figure 5. 18 18

19. Figure 3 19

20. Figure 5 20

21. 4. Rational Expectations in an AD-AS Model: A New Classical Perspective An unexpected expansionary monetary policy temporarily increases output (see Mishkin, Chapter 25, Figure 1). An expected expansionary monetary policy does not increase output even temporarily (see Mishkin, Chapter 25, Figure 2). An expansionary monetary policy that is less expansionary than the market expects will cause output to fall (see Mishkin, Chapter 25, Figure 3). 21

22. 22

23. 23

24. 24

25. Implications of rational expectations (in the absence of wage-price stickiness): • Policy ineffectiveness proposition: only unanticipated policy interventions have an affect on real output. Anticipated policies, however, can still impact on the price level. • Policy makers cannot know the outcomes of their decisions without knowing the market’s expectations of them. • Market participants try to guess what policymakers are planning to do. Expectations do not remain fixed while policy makers plan a surprise. • Stabilization policies are unlikely to work since they typically imply predictable policy interventions. • High profile New Classical economists include Lucas, Sargent, Prescott and Barro. 25 25

26. 5. Rational Expectations in an AD-AS Model: A New Keynesian Perspective The New Keynesians (e.g., Mishkin himself and Akerlof) while accepting the merits of the rational expectations framework argue that wage-price stickiness in the market invalidates the policy ineffectiveness proposition. They argue that an anticipated expansionary monetary policy intervention will increase real output in the short run since wage contracts and contracts for non-labour inputs will prevent factor input prices from immediately fully adjusting. The New Keynesian position on the distinction between unanticipated and anticipated expansionary policy interventions is shown in Mishkin, Chapter 25, Figure 4. The difference is a matter of degree. In both cases, real output rises. But real output rises more under unanticipated policy interventions. 26 26

27. Figure 4 27

28. The New Classical and New Keynesian positions are contrasted in Mishkin, Chapter 25, Figure 5. 6. Anti-Inflation Policies Suppose the economy has settled into a 10 percent inflation equilibrium. That is, everyone expects 10 percent inflation and this is what actually happens. Output is at the natural rate Yn. This means that wages rise by 10 percent per year (assuming real wages are constant), and the AS curve shifts leftwards each year. Output is maintained at Yn since the AD curve shifts rightwards (the money supply also rises by an offsetting amount). See Mishkin, Chapter 25, Figure 6. 28

29. 29

30. 30

31. Suppose that the central bank wants to get inflation down to zero, and hence announces that it will stop increasing the money supply (this stops any further rightward movement of the AD curve). What happens to output in the short-run now depends on market expectations. Possible outcomes: • New Classical case (fully flexible wages): If the market believes the central bank will stick to its anti-inflationary plan, everyone switches to expecting zero inflation. In this case, the AS curve immediately stops shifting leftwards. Inflation drops to zero without any associated short-run decline in output below the natural rate Yn. 31

32. If the market does not believe that the central bank will stick to its anti-inflationary plan, then the AS curve continues shifting leftwards. The result is a recession. At this point one of two things should happen. • Market participants start believing that the central bank is serious and the AS curve shifts back to the right reducing inflation to zero and ending the recession. • The central bank loses its nerve and we return to the inflationary equilibrium. 32

33. (ii) New-Keynesian case (sticky wages): If the market believes the central bank will stick to its anti-inflationary plan, everyone switches to expecting zero inflation. However, not all wages adjust immediately to the new scenario. Hence the AS curve still shifts to the left and there is a recession (although a smaller recession than if the central bank lacked credibility). Once all wages have had time to adjust, the economy converges to the new zero-inflation equilibrium. If the market does not believe that the central bank will stick to its anti-inflationary plan, then the outcome is the same as under the New Classical case.