Rational expectations happen to be a basic tool for modern mainstream economics, New Classicals and New Keynesians alike. Critically analyse the basis of this assumption.

The hypothesis of rational expectations ascertains that the economic agents are unaware of the future events due to the uncertainty and due to this their decisions are based on their future expectations. By using all information which is available with economic agents, they make rational expectations of the future so that best possible forecasts can be made. Focus of the rational expectations approach is that it is a possibility that forecasts by economic agents may not always be accurate but while forming expectations agents do not make systematic errors.

Also rational expectations model deals with the equilibrium state in which markets immediately clear. This asserts that agents don’t have faith in money wage stickiness as well as price stickiness. If firms fix prices and wages on the rational expectations basis then price and wages will be set at those levels where both products as well as labour markets will be in a state of equilibrium.

The model of rational expectations was developed against the prevalence of both high inflation and employment in the US economy. But the coexistence of high inflation rate and hig unemployment rate contradicted the Keynesian theory. The model of rational expectations is also called neo classical economics as it reestablishes many of the classical concepts as well as policy prescriptions. Rational expectations model comprises of some aspects of classical economics and reaches to the concluding remark of non interventionist policy by the government to keep a check on the fine tuning of the economy such that macroeconomic stabilization can be achieved.

The model of rational expectations is basically a critique of Keynesian theory as the new classical economics ascertained the Keynesian system as fundamentally flawed. They gave the policy ineffectiveness postulate as they questioned that whether the government’s monetary and fiscal policies are useful in achieving macroeconomic stability in the real sense or not. They show that the policies which are demand managing don’t affect economies real variables like output and employment.