I tried to write a joke about macroeconomic forecasting to open this blog entry, but you've probably already anticipated the punchline and priced it in. That, in a nutshell, is the core of Rational Expectations.

Before the 1970s, economists mostly assumed expectations were adaptive. People looked in the rear-view mirror. If inflation was 3% last year, workers demanded a 3% wage hike this year. This allowed governments to easily stimulate the economy: they could boost aggregate demand, inflation would rise slightly faster than wages, and real labor costs would fall, prompting firms to hire more workers.

Economists like John Muth and Robert Lucas flipped this on its head. The Rational Expectations theory argues that economic agents don't just look backwards. They use all available information—including an understanding of government policy—to look forwards.

If the Bank of England announces an expansionary policy, trade unions and firms don't wait a year to see what happens. They rationally expect inflation to rise, so workers demand 5% wage increases immediately, and firms instantly raise prices to protect margins.

The Death of the Short-Run Phillips Curve

In your exams, the best way to apply this is through the Phillips Curve. Under adaptive expectations, there is a short-run trade-off between inflation and unemployment. But if expectations are rational, that short-run curve vanishes.

When the government attempts to stimulate demand, the expected inflation rate adjusts instantaneously. The Short-Run Phillips Curve (SRPC) shifts upwards immediately, meaning inflation spikes but unemployment doesn't fall at all. We jump straight to the Long-Run Phillips Curve (LRPC) at the natural rate of unemployment. This is known as the policy ineffectiveness proposition.

While rational expectations makes a great theoretical argument, New Keynesians will always push back. Even if a UK firm rationally anticipates 5% inflation, they might be locked into a two-year union contract or face steep "menu costs" to change their prices. These real-world frictions mean monetary policy still has some short-term bite, even when agents are looking forward.