Explain why rational expectations theorists do not support government intervention to alleviate unemployment. Explain their views on the effectiveness of fiscal policy and monetary policy

Answer 1

Rational expectations theorists believe that anticipation of fiscal or monetary policy undermines the policy. They believe that workers are smart enough to learn from experience how to overcome the effects of the government's policies. If the government tries to cut unemployment with fiscal policy, workers will expect inflation and will try to prevent inflation losses by instantaneously demanding higher wages. This undermines fiscal policy by eliminating any short-run price-cost gap, thus removing the incentive for firms to hire extra workers. Similarly, if the Fed uses monetary policy to end a recession, workers and firms will expect inflation to occur, and will respond instantaneously. Workers will demand higher wages, and firms will demand higher prices resulting in a higher price level.