Questions: Rational Expectations in Macroeconomics

Question 1

Under rational expectations, when a central bank credibly announces a future interest rate increase, when do private agents adjust their expectations?

• A. Gradually, over several periods as evidence accumulates
• B. Only after the rate increase is actually implemented
• C. Immediately, because the announcement is itself new information
• D. Never, because agents distrust central bank announcements

Answer: (C)

Under rational expectations, agents use all available information — including credible policy announcements — and update immediately. This is why central bank forward guidance can affect bond yields and spending decisions before any rate change occurs. Gradual adjustment is characteristic of adaptive expectations, not rational expectations.

Question 2

Rational expectations implies that economic agents can perfectly predict future outcomes.

• T. True
• F. False

Answer: False

Rational expectations means forecasts are unbiased on average and efficiently use available information — not that agents are omniscient. Agents still make forecast errors; they simply do not make systematic, correctable errors. The distinction is between unbiasedness (no predictable pattern in errors) and accuracy (no errors at all).

Question 3

What is the Lucas critique, and why does it challenge the use of historical econometric models for policy evaluation?

Model answer: The Lucas critique argues that when policymakers change their rules, rational agents change their behavior in response, invalidating relationships estimated from pre-change historical data. A model built on past behavior assumes fixed decision rules, but if agents expect a new policy regime, they update their expectations and act differently — making the old model's predictions unreliable.

This is the central policy-relevance insight of rational expectations. If you use a model estimated under one policy regime to predict outcomes under a different regime, you are implicitly assuming agents won't notice or respond to the change — which contradicts rationality. Lucas argued that only models grounded in 'deep parameters' (preferences, technology) that are policy-invariant can be used reliably for policy evaluation.