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.