The following story illustrates forward-looking behavior, which is part of the theory of rational expectations. When Lucas Sargent declared his college major, he sketched out a plan for his courses for the next two or three years. He based his plan on the course requirements set out in the university catalog and his expectation that these requirements would continue. Also suppose that a very difficult, poorly designed course is required in Lucas’s major. Everyone is complaining about the course, but since it is required, Lucas decides to stay with his plan and register for it for the second term. Many other majors do the same thing. Next, suppose that the word gets out that the faculty has voted to eliminate this requirement for the major. This curriculum change, however, must go through university procedures and thus will not be finalized until next year. Lucas visits with other students and concludes that this change will most likely happen. He therefore changes his registration for the second term, substituting another course for the one in question. Because many other students also opt out, registration for the course plummets for the second term, surprising the faculty. Lucas and the other students initially registered for this course based on a particular expectation about the future: that the course would be required. The policy change produced a new expectation about the future: that the course would no longer be required. This new expectation led students to alter their present behavior. Lucas and his fellow students changed their current behavior based on rational expectations.

Photograph courtesy of: (c)Corbis # CBO39236;

19.2 Rules versus discretion button

Keynesian economist Abba Lerner (1903-1982) likened the economy to an automobile traveling down a curvy road that had traffic barriers on each side. The problem was that the car had no steering wheel. It would hit one barrier, causing the car to veer to the opposite side of the road. There it would hit the other barrier, which in turn would send it careening to the opposite side. To avoid such careening in the form of business cycles, said Lerner, society must equip the economy with a steering wheel. Discretionary fiscal and monetary policy would enable government to steer the economy safely between the problems of recession and demand-pull inflation. Economist Milton Friedman (b. 1912) modified Lerner’s analogy, giving it a different meaning. He said that the economy does not need a skillful driver of the economic vehicle who is continuously turning the wheel to adjust to the unexpected irregularities of the route. Instead, the economy needs a way to prohibit the monetary passenger in the back seat from occasionally leaning over and giving the steering wheel a jerk that sends the car off the road. According to Friedman, the car will travel down the road just fine, unless the Fed Reserve destabilizes it. Lerner’s analogy implies an internally unstable economy that needs steering through discretionary government stabilization policy. Friedman’s modification of the analogy implies a generally stable economy that is destabilized by inappropriate monetary policy by the Federal Reserve. For Lerner, stability requires active use of fiscal and monetary policy. For Friedman, macroeconomic stability requires a monetary rule forcing the Federal Reserve to increase the money supply at a set, steady annual rate.

Photograph courtesy of: (c)Nance Trueworthy;