Chapter 16
Rational Expectations Theory
regard people's expectations as crucially important in creating business cycles. Rational expectations theories focus on people's expectations about future fluctuations in aggregate demand. The New classical theory of the business cycle claims that only unexpected changes in aggregate demand create business cycle fluctuation in economic activity. The New Keynesian theory of the business cycle asserts that both unexpected and expected fluctuations in aggregate demand can create business cycles.
The figure to the right shows the rational expectations view of a recession. Aggregate demand was expected to be at EAD, but the actual aggregate demand decreased from what was expected, EAD, to AD1. As a result, the economy moves along its short-run aggregate supply curve SAS and real GDP decreases from $7.0 trillion to $6.5 trillion. As real GDP decreases, unemployment increases and the economy goes into recession.
However, the economy does not stay in the recession. Eventually, the actual aggregate demand equals the expected aggregate, perhaps because the actual aggregate demand increases, as shown in the figure on the left. In the figure, actual aggregate demand increases to AD2, which eventually equals the expected aggregate demand, EAD. Thus in the long run the economy automatically returns to potential GDP and the recession ends. To examine the other business cycle theories, click on the figure you want below. To see the summary, click on the summary figure.