Ties between the General Equilibrium Theory and Rational Expectations Economics - Essay Example

Name: Tutor: Title: Question Five Institution: Date: Question Five “Is rational expectations economics connected to general equilibrium theory? How, why? What are the fundamental weakness of both general equilibrium theory and rational expectations economics?” Connection of Rational Expectations to General Theory There is a connection that exists between the general equilibrium theory and rational expectations economics. The two theories do not independently exist without having to borrow facts from the other theory. Rational expectation derives its logic from the market situations that are realized in the multiple markets as discussed by general equilibrium theory. The aspects that are discussed in the market have the same effect in the rational expectations economics as well as the general equilibrium theory. The two theory will be explores and the manner in which they are connected to each other will be examined. Rational expectations is a concept in economics which expostulates that predictions of agents concerning the future relevant variables economically are not wrong systematically in such a way that present errors are random. In this case, agents within the model have an assumption that the model’s predictions are valid (Petri, 2004 p.56). Rational expectations are applied in various contemporary models of macroeconomics, game theory, and applications of rational choice theory. Rational expectations concept commence with the belief that people do not have to make mistakes that are systematic. Agents learn from their mistakes, and they form insightful inferences concerning what is going to unfold in the future (Keita, 1992 p.102). Available information enables the agents to make decisions which are rational based on experiences from the past. These expectations affect demand and supply of commodities in the market. Experimental psychology altered its focus to mass minds from individual minds. It became more concerned about on administrative decisions rationalization as opposed to increasing knowledge in psychology. The effects of the Great Depression compelled econometricians to use methods of standard statistics which were advanced for the purpose of analyzing experiments in the laboratory in an effort to come up with models of the whole economies which were punctuated with agents that are anonymous (Arrow & Debreu, 1954 p.271). The aim was to design and rationalize policies that are effective for altering economic systems. In this perspective, the government was viewed as behaving precisely as one of the agents having rational expectations. By the year 1950, is when the expectations of the agents were incorporated in to kind of adaptive expectations hypothesis. For almost twenty years, agents used extrapolated rules that are backward looking for the purpose of forecasting error in order to revise prevailing expectations. Structural estimations were highly criticized in the 1970s. The decisions that agents grapple with in the rational expectations theory are the same decisions that are studied under the general equilibrium theory. The agents that are being looked at in the rational expectation economy are also looked at in the general equilibrium theory. The two theories are closely related since they are both concerned with forecasting the future with the aim of making rational decisions which affect agents in the market. Agents will make decisions after the study the situation in the market which can only be done by studying the general equilibrium theory. General equilibrium gives an analysis of situation in the various markets to enable effective decisions making (Heckman, 2000 p.72). It is all about prediction of the future events that have an impact in the situation of the economy in a particular context. The agents in the rational expectation theory cannot have an informed decision without studying the situation in the market. Problems of inflation and unemployment have continued to affect the stability of the modern society. Post-Keynesians theory can be seen as a generation of ideas from both neo-Keynesians and Keynesians. The basic disagreement of the post Keynesian school is that the general equilibrium theory cannot adequately explain actual empirical events happening in the general economy (Stiglitz, 2000 p.1459). The basic theme of post-Keynesians theory is that economic analysis can be important only if they are empirically grounded. Sonnenschein-Mantel-Debreu cannot be to a particular, choice of individual preferences that are rigid, or to a specific income distribution. Instability full range is bound to result in the general equilibrium model. General equilibrium theory looks at demand and supply fundamentals within an economy having numerous markets, with the aim of demonstrating that all the prices are at equilibrium. The theory looks at the mechanism through which the economic agents’ choices are correlated in all the markets. The distinction of general equilibrium theory from partial equilibrium is that it tries to analyze several markets at the same time as opposed to isolation of a single market. The theory was first advanced by Leon Walrus in the 1870s. Walrus stated that pure economics is basically the theory which involves price determination following a free competition within a hypothetical regime (Black, 1995 p.318). The current concept of the theory was advanced jointly in 1950s by Mackenzie, Debreu, and Arrow. General equilibrium theory analyzes economies by application of model of equilibrium price and tries to demonstrate the circumstances in which the general equilibrium assumptions will be proven. The theory of general equilibrium views the economy as an economic agents’ collection that effect demand and supply decisions over labour types, assets, and commodities with the goal of furthering their interests. General equilibrium points at a positive representation of the behavior of some economic phenomena; it received the type of scrutiny which positive theories in economics receive routinely (Starr, 1969 p.29). General equilibrium assists in the deliberations that go on in rational expectations economics. The discussions in rational expectations economics would not be possible without the support of the general equilibrium theory which points out the situation in various markets. Rationality can only be talked about in a situation where there is possible prediction of future events in the economy (Smith, 2003 p.121). The agents of decisions making that result in general equilibrium have also rational expectations concerning future outcomes. The two theories integrate to provide meaning interpretation of concepts in economics. Factors of price, unemployment, interest rates, and inflation are both involved in rational expectations and general equilibrium theory. Fundamental weakness of rational expectations economics Rational expectations economics, just like general equilibrium theory has received a share portion of criticism. There is a prevalent and misled belief concerning rational expectations depriving the authorities of power to stabilize unemployment and output. This is false. All things rely on the assumptions of the model where rational expectations model is inserted. The ineffectiveness of policy of macroeconomics to influence unemployment does not come from the hypothesis of rational expectations, but from the insistence of New Classical on market clearing that is continuous (Arestis & Sawyer, 2006 p.97). However, it is allied to the natural hypothesis. There is also the problem of durability of physical capital assets. In case the expectations was on which some invested is founded on today was mistaken, it cannot allow a chance of reserving the decisions that has already been done. There are many times that agents in the market are considered to be irrational and hence casting doubts on the credibility of the theory. Fundamental weakness of general equilibrium theory It has been demonstrated that there are weaknesses with the general equilibrium model. It was found out that restrictions on the shape on functions of excess demand are stringent. It is also explained that a model founded on the tatonnement process is a model of an economy which is centrally planned, as opposed to a market economy that is decentralized (Walras, 1954 p.65). One of the criticisms of the general equilibrium model is the assumption that instability is the model’s artifact which is generated by unrealistic or uncommon conditions, or the assumed market mechanisms nature. Investigations along these perceptions have been unable to realize revival of general equilibrium; on the other hand they have resulted into failure of the theory. In the 1970s theorists agreed on strong and mostly negative conclusions concerning the stability and uniqueness of the theory of general equilibrium. There are some restrictions on aggregate demand nature that provides equilibrium’s uniqueness, but there is no convincing case developed for economic realism of the restrictions. There have been illustrations three-commodity, three-person economies having permanently price dynamics that are unstable. Consequently there is no an iota of hope of stability of general equilibrium being proven. The representation bout stability demonstrated by Debreu (1974 p.42), Mantel (1974 p.50), and Sonnenschein (1972 p.67), is that about all continuous pattern of movement of prices can happen in the model of general equilibrium, provided that the population of consumers exceeds the number of goods. Therefore, cycles of any magnitude and any other disturbances are bound to occur in a model of general equilibrium for particular set of initial endowment and consumer preferences. This shows that general equilibrium cannot be relied upon as being stable, and its dynamics can culminate into destructions of unimaginable magnitude. The concept of general equilibrium can hardly be proven in many circumstances although it tries to explain some situations in the market. The problem seems to arise in the essential characteristics of traditions in economics that have a long history. This involves treating individuals in a way that they are act independently of one another (Mandler, 1999 p.69). This independency of behavior individual plays an important role in the building of economies coming up with demand functions that are arbitrary excess. Despite the weaknesses of the theory, general equilibrium is vastly used in explanation of economic situations. Some of the criticisms do not hold enough prove of justification. Bibliography Petri, F., 2004, General Equilibrium, Capital, and Macroeconomics: A Key to Recent Controversies in Equilibrium Theory, Northampton: Edward Elgar Publishing. Walras, L., 1954, Elements of Pure Economics, New York: Irwin. Starr, R.M., 1969, Quasi-equilibria in markets with non-convex preferences. Econometrica 37 (1): 25–38. Black, Fischer (1995). Exploring General Equilibrium. Cambridge Mass: MIT Press. pp. 318 Arrow, K. J. & Debreu, G. (1954). The Existence of an Equilibrium for a Competitive Economy, Econometrica, vol. 22, 265-90. Mandler, M., 1999, Dilemmas in Economic Theory: Persisting Foundational Problems of Microeconomics, Melbourne: McGraw Hill. Keita, L.D., 1992, Science, Rationality, and Neoclassical Economics. Delaware: University of Delaware Press. Heckman, J.J., 2000, Causal Parameters and Policy Analysis in Economics: A twentieth century retrospective, in: The Quarterly Journal of Economics Vol.115, 45-97. Stiglitz, J.E., 2000, The contributions of the economics of information to twentieth century economics, The Quarterly Journal of Economics Vol.115, 1441-1478. Smith, S.W., 2003, Labour Economics, Routledge: Melbourne. Arestis, P. & Sawyer, M.C., 2006, A Handbook of Alternative Monetary Economics, Northampton: Edward Elgar Publishing. Read More