Chapter 25
The Role of Expectations in Monetary Policy
Over the last thirty years, the role of the public and the market’s expectations has moved to the
front and center of the thinking about how the macro economy works. Chapter 25 discusses the
most widely used theory to describe the formation of household and business expectations—
rational expectations—and develops it from microeconomic principles. Using the AD/AS model
developed earlier in the book, it then explores how this theory has shaped current policy-making
and debates.
The chapter next turns to a set of policy issues. The first is the debate over whether policymakers
should follow rules or instead conduct policy with complete discretion, in which policy is
conducted on a day-to-day basis. The argument for rules is based on the time-inconsistency
problem, another one of the most important ideas in macroeconomics over the last thirty years.
The problem with discretion is that policymakers can’t commit to good long-run strategies.
Instead they have incentives to renege on the good strategy and therefore pursue policy that leads
to poor outcomes. I like to illustrate this concept in class by presenting everyday examples. One
is how we eat. We don’t want to eat unhealthy food, but when we see that juicy hamburger, we
just can’t resist it. Another example is the inability to stay on a diet, as discussed in the text. I
also like discussing the problem of child rearing and the temptation to give in to bad behavior.
crisis did).
Students also enjoy historical examples showing how credibility is critical to the success of anti-
inflation policies. The box on ending the Bolivian hyperinflation drives home the importance of
credibility because it is so dramatic. The application that discusses credibility and the Reagan
budget deficits asks the student to use the analysis he or she has learned in this chapter to see if