Paper Example. Role of the Central Bank

Published: 2023-03-26
Paper Example. Role of the Central Bank
Type of paper:  Essay
Categories:  Politics Macroeconomics Banking Financial analysis
Pages: 7
Wordcount: 1885 words
16 min read

The rational expectation framework is a modeling technique and concept that has been widely adopted in macroeconomics. The theory posits that people base their decision on certain factors which involve and not limited to their experience, information available to them, and past experiences. It assumes that people can be in a position to impact the future state of the economy using their current expectations of the economy. As such, this idea coincides with the government's monetary policies, which can impact on the future economic state. Most governments have adopted the concept of rational expectation due to its advantages over the past framework, such as adaptive expectation. After the introduction of reasonable expectations, policymakers usually apply the doctrine of rational expectation to anticipate aspects of output and inflation. This analysis shows how the adoption of reasonable expectations alters scope for politicians to influence the production and inflation and the role of the central bank in these circumstances.

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Understanding the meaning of rational expectation can help in determining how its application impact on policymakers scope of to influence output and inflation. When the term reasonable expectation was coined in 1961, it was given specific technical meanings that could be connected to economic models. However, in lay man's language, rational expectation relates to naturally people's behaviors. This theory claims that people usually make a decision regarding all the information available to them while considering the future consequences of their choices (Nelson, 2017). As such, people will tend to apply the information available to them to ensure that they would not repeat their past mistakes. In this case, the data will involve approaches government take when economic signal start changing and knowledge about the about policies actions already taken and their implication. The implication is that rational expectations attribute to people a broader and thorough view approach on matters that are going to cause a difference in their dollars. However, since reasonable expectations developed as a result of the application of a traditional way of perceiving the economy and the role of the policy to control aspects of output and inflation, it is mainly against these views. It challenges the traditional mechanisms that were being applied by the government for fiscal and monetary restraint in a time of boom and stimulus during a recession. The idea was that, in the long run, these regulations would improve the economic performance for the general wellbeing (Blanchard, 2018). However, the application of rational expectations would frustrate the policymakers when trying to regulate output or the inflation rate.

Rational expectation will make people change their labor behavior, making it hard for policymakers to influence output. During a recession, a government would want to increase production to regulate economic performance. To attain this, it usually encourages private sectors to produce more. As such, it increases the supply of money in the economy, which is done by aspects such as lowering interest rates. In other words, the government will increase expenditure on goods and services while reducing what is correct from private sectors as taxes. When this happens, the private sectors see an opportunity to make a profit, and hence they hire more labor, and other new firms also emerge. However, the expectation is that the level of the wages will barely remain the same, for the aim is to make the profit of the private sectors go up while the cost of production remains low. When labor remains law, firms will be encouraged to hire more workers, and eventually, the output will also increase. However, in this scenario, though wages will remain unchanged, the prices of good will rise. What happens is that workers find themselves in a peculiar position of offering more labor at a lower real wage rate (Blanchard, 2018). According to Hatcher and Minford (2016), actual wage rates are an indicator of wage people early concerning the cost of goods they will purchase. For the policymakers to effectively influence the output, this kind of short-sightedness is a fundamental aspect. This is because, if the workers were full of anticipating wages rise accordingly, then this policy system cannot work. This system used by the policymakers is known as the Keynesian theory, and it handily violates the mechanist that is believed by policy activists to be applied by the government to regulate the economy during certain conditions. The policymakers expect the workers to be tolerant regarding the fact that the price levels will erode the goods and services they can purchase with their wages. As it may, though, this can be perceived as irrational, primarily because of being discriminative to the workers, it is considered as an effective mechanism for the government to resolve the challenge of recession in an economy on whole better off.

Though this type of mechanism has been used by the policymakers to influence the economy effectively, it cannot be used with the introduction of rational expectations because it hardly seems logical. Various aspects will make such a mechanism of policymaking impractical. To start with, this type of policy can only work if the labor does not in job-seeking behavior, and wage-bargaining anticipate consequences, which will be increased in price. Policymakers would have a hard time to set this wage setting and price disparity if such policies were expected or predicted. This is because labor cannot knowingly or willingly enter into a contract that shrinks real income while no change in productivity or technology has occurred. In this case, the workers will bargain for an increase, and the private sector will lack an opportunity to exploit (Fratianni & Nabli, 2015). Secondly, a system such as this on Keynesian that works on fooling workers cannot operate when people use rational expectations. It may work once, but workers will then learn from their experience and hence respond quickly to any changes in price. Labor will counter the government misleading by an aspect such as shortening the contract period next time. When the contract is short, the labor union will have an opportunity to bargain labor costs frequently, and this will limit the scope of policymakers to influence output by taking advantage of labor. Another alternative used by labor-union to respond is to stay in a long-term contract but base them on a better forecast of inflation. The implication is that a perfect estimate in labor can be seen in the extent to which laborers achieve wages adjustment in response to cost-of-living indexes. In other words, adjusting wages concerning the cost of living indexes is the correct point of view of the rational expectation, and this will challenge the application of the Keynesian mechanism by the policymakers to impact on output (Tobon, 2014). The high number of people who are now covered by the cost of leaving cost in their contract is an illustration of how labor is responding in a rational way to policy maker's continuity failure to deliver its containment of inflation policy goals it announced.

The other way on how the introduction of rational expectation limit the scope of policymakers to influence output and interest occurs in the interest rate channels. This shows the notion of policymakers that is used to regulate the economy to either reduce inflation or increase production. Similar to the above-discussed perspective, this system depends on the short-sightedness of fund suppliers on their real interest earnings. The assumption is that by altering the money, growth will impact consumer spending decisions and business expansion. When the economy is or going into recession, the policymaker will tend to expand the money supply growth rate. This is done through the Federal Reserve stepping in and buying securities from the public. By doing so, the banks end up with new reserves that can be used to expand loans to firms, and the public ends up with the flow of new cash. In this action, the purchase of securities by the Federal Reserve hike the prices of securities and interest on those securities are brought down. Since the banks will start finding ways to lend money than usual, other interest rates will also go down.

What happens is that firms will expand investment in new facilities. This assumption is similar to that of labor discussed above as it will make firms attain loans at a lower interest while profit remains the same. This will help in ensuring that new workers are employed and output increases. With this, policymakers will have attained their goal of influence output and unemployment (Nelson, 2017). However, this will not be available in the introduction of rational expectations. What happens is that the money lenders might not act as expected. They will tend to predict possible inflation that will make them receive a lower interest rate in the future. As such, they may decide only to provide loans in a shorter period to avoid losing some interest that might be caused by inflation. The other alternative used by money lenders is to add inflation premium to the interest rates they are willing to settle on. The implication is that finally, the interest rates will settle at the expected inflation as a rationalist would argue to foresee. All costs will go up against such that there will be no exploitable profit to be used by policymakers to influence either output or inflation (Frommel, 2017). The scope of policymakers to control interest and production will be limited whenever any quick sensed signals or policy moves are expected.

In these circumstances, the central bank has a role to play. Generally, the part of the central bank is to ensure that the rate of inflation goes down, stabilizing the economy during the recession and also reducing the unemployment rate. However, these roles have been challenged by the introduction of rational expectations. For example, in the case when the central bank wants to increase the output, using the labor mechanism, this will be impossible since rationalism will also mean increasing the labor cost, and hence output remains the same. On the other hand, whenever the central bank tries to influence production by lowering interest rates. Moneylenders use rational expectation to predict that there is a foreseen inflation and hence add inflation-premium in such a way that interest rate becomes equal to foreseen inflation. Accordingly, nothing would change in terms of output. In this circumstance, the role of the central bank will, therefore, be to dictate the interest rate to the money lenders. In case of trying to reduce inflation, renders may predict that inflation will be short-lived and hence consider lending at lower or regular interest forecasting that eventually inflation will go down and thus those they have to lend the money will end up paying with the standard interest rates (Goodhart, 2016). As such, the policy of dictating interest rated during these circumstances will be vital to the central bank.

Rational expectation introduction has changed the scope of policymakers to impact on inflation and output. The traditional mechanism they used to control the economy during inflation, recession, and to reduce unemployment seems impractical in the age of rational expectation. As such, the role of the central bank in these circumstances is to give policies about the interest rate for the lenders to ensure that they do not rely on foreseen inflation to hike interest rates.


Blanchard, O. J. (2018). The monetary mechanism in the light of rational expectations. In Rational expectations and economic policy (pp. 75-116). University of Chicago Press.

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