Chapter 12: Problem 3

Would it make sense to argue that rational expectations economics is an extreme version of neoclassical economics? Explain.

Short Answer

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Rational expectations economics can be seen as an evolution and extension of neoclassical economics. It builds upon the rationality assumption and market focus of neoclassical economics but refines it by accounting for imperfect information and incorporating learning mechanisms. Hence, it may not be accurate to describe rational expectations economics as an extreme version of neoclassical economics. Instead, it could be considered a more realistic and refined version that enhances the foundational concepts of neoclassical economics.

Step by step solution

Understanding Neoclassical Economics

Neoclassical economics is an economic theory that emphasizes the role of the market in determining prices and resource allocation. According to this theory, individuals and firms will act rationally by maximizing their utility and profits, respectively. Neoclassical economics relies on the assumption of perfect information, which means that all market participants possess accurate and complete information about market conditions.

Understanding Rational Expectations Economics

Rational expectations economics is a concept introduced into the mainstream by Robert Lucas in the 1970s, which extends and refines neoclassical economics. It is a theory that predicts how individuals and firms form their expectations about key economic variables, such as inflation rates and unemployment. According to this theory, individuals and firms have rational expectations and will use all available information to make optimal decisions. Unlike neoclassical economics, rational expectations economics assume that individuals and firms can learn from past experiences and adapt to changing circumstances.

Comparing Neoclassical and Rational Expectations Economics

Both neoclassical and rational expectations economics rely on the assumption that individuals and firms are rational and utility/profit-maximizing. Furthermore, both theories place an emphasis on market forces determining outcomes. In terms of differences, neoclassical economics is based on perfect information, whereas rational expectations economics recognizes that information may be imperfect but allows individuals and firms to learn and adapt to the imperfections.