Theories of Expectations Including Rational Expectations and Their Uses in Different Versions of the Philips Curve

Abstract

Expectations are used in almost every branch of economics. And alternative theories of expectations have been developed, including the theory of rational expectations (RE) introduced by Robert Lucas (Jr.). The use of RE in macroeconomic models has changed radically many well-developed earlier results and policy prescriptions. The purpose of the present paper is twofold—first, to discuss the various theories of expectations, and secondly, to show how the Phillips curve in macroeconomics dealing with the celebrated trade-off between inflation and unemployment—yield different results, if alternative expectations mechanisms are used. We thus discuss different versions of the Phillips curve—first, its initial version due to Phillips, showing the existence of a permanent trade-off between inflation and unemployment, next the Friedman–Phelps version using static expectations and showing the existence of only temporary, but no permanent trade-off, and finally, the new classical version with rational expectations showing the absence of any trade-off even temporarily. We add that no new result has been proved here; rather, our objective is mainly to help the students to understand these topics clearly—students who might have felt that the discussion of these topics in the standard textbooks is not always up to expectation.