Rational Expectation Theory (RATEX)

Meaning:

New classical economics based on rational expectation hypothesis was put forward by Robert Lucas of the University of Chicago. Rational Expectation theory which is the corner stone of recently developed macro-economic theory, popularly called new classical macroeconomics. Friedman’s adaptive expectation theory assumes nominal wages lag behind changes in the price level. This lag in the adjustment of nominal wages to the price-level brings about rising business profits which induces the firms to expand output and employment in the short run, and leads to the reduction in unemployment rate. But according to the Ratex theory, there is no lag in the adjustment of nominal wages consequent to rise in price level. The advocates of this theory further argue that nominal wages are quickly adjusted to any expected changes in the price level. According to the Ratex theory, as a result of increasing aggregate demand, there is no reduction in unemployment rate, the rate of inflation resulting from increasing aggregate demand is fully and correctly anticipated by workers and business firms and get completely and quickly incorporated into the wage agreement resulting in higher prices of products.

The price level in the diagram, the price level rises the real output and employment remaining unchanged. Aggregate supply curve according to the RATEX theory is a vertical straight line at potential GNP level, given the resources and technology. 

RATEX theory rest on two basic elements, 1:- according to it, workers and producers being quite rational have a correct understanding of the economy and therefore correctly anticipate the effects of government economic policies using all the available relevant information in the basis of these anticipations of effects of economic events the governments, policies. They take correct decision to promote their own interest. The second premise of RATEX theory is that, like classical economists, it assumes that all product and factor markets are highly competitive as a result wages and product prices are highly flexible and therefore can quickly change upwards or downwards. The RATEX theory considered new information is quickly taken into account in the demand and supply market, so that new equilibrium price immediately adjusts to new economic events and policies. Be it new technological change or supply shock in terms of draught or act of OPEC oil cartel or changing governments monetary and fiscal policies.