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John Muth's Rational Expectation Theory

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• Define Financial Shock

According to Wright, R. E., & Quadrini, V. (2009), Financial shocks and crises affect the real economy by increasing asymmetric information. By so doing, A financial shock is an unpredictable event that affects the financial and money markets in a positive or negative manner. In other word, a financial crisis occurs when one or more financial markets or intermediaries cease functioning not consistent or regular and incompetent.

Moreover, Study also highlights that five shocks have a strong natural tendency to cause or facilitate the financial crises as follows: Interest rate increases, stock market declines, uncertainty, balance sheet deterioration, and fiscal imbalances. These aforementioned shocks tend to increase …show more content…

His rational expectations theory was developed as a challenge to some of the ideas regarding aggregate demand from classic economist John Maynard Keynes. The theory of rational expectations says that because people are forward-looking and rational (as opposed to emotional), actual outcomes will turn out to be very close to the expectations of all the players in the economy.
The theory of rational expectations can be directly applied to the labor market - specifically, what happens to unemployment. The rational expectations theory predicts that, because companies and workers rely not only on past information but also make predictions about the future, the labor market will generally be in equilibrium most of the time, so unemployment is at its natural rate.

Rational expectations theory also leads to the conclusion that, although the government can help reduce the unemployment rate, their actions will only lead to higher prices. Since unemployment is basically at equilibrium most of the time, any actions by the government to alter its level will unnaturally disrupt the economy's price level. Therefore, the government should not …show more content…

The rational expectations theory is often used to explain expected rates of inflation. For example, if inflation rates within an economy were higher than expected in the past, people take that into account along with other indicators to assume that inflation may further increase in the future.
The rational expectations theory also explains how producers and suppliers use past events to predict future business operations. If a company believes that the price for its product will be higher in the future, for example, it will stop or slow production until the price rises. Since the company weakens supply while demand stays the same, the price will increase. The producer believes that the price will rise in the future and makes a rational decision to slow production, and this decision partially affects what happens in the future. By relying on the rational expectations theory, companies can inadvertently effect future inflation in an economy.

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