PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 11 Rational Expectations, New Classical Macroeconomics, and Efficient Markets

Copyright © 2004 South-Western. All rights reserved.11–2 Fundamental Issues 1.What is the distinction between adaptive and rational expectations? 2.What are the key assumptions underlying new classical macroeconomics? 3.How do policy anticipations determine the actual effects of policy actions in the new classical model, and what is the new classical policy ineffectiveness proposition?

Copyright © 2004 South-Western. All rights reserved.11–3 Fundamental Issues 4.What is the efficient markets theory, and what is its main implication? 5.How are exchange rates determined, and what is foreign exchange market efficiency?

Copyright © 2004 South-Western. All rights reserved.11–4 Expectations and Macroeconomics Adaptive Expectations:  Expectations that are based only on information from the past up to the present. Rational Expectations Hypothesis:  The idea that individuals form expectations based on all available past and current information and on a basic understanding of how the economy works. Representative Agent Assumption:  The assumption that all people in an economy have access to the same information and have the same understanding of how the economy works.

Copyright © 2004 South-Western. All rights reserved.11–5 Figure 11–1 Real Output and Price-Level Determination in the New Classical Model

Copyright © 2004 South-Western. All rights reserved.11–6 Anticipating Policy Actions Fed Watching:  An occupation that involves developing and selling forecasts of Federal Reserve monetary policy actions based on careful examination of the process by which the Fed appears to make its policy decisions. Efficient Markets Theory:  A theory that stems from applying the rational expectations hypothesis to financial markets; it states that equilibrium bond prices should reflect all past and current information plus bond traders’ understanding of how bond prices are determined.

Copyright © 2004 South-Western. All rights reserved.11–7 Currency Exchange Spot Exchange Rate:  The rate of exchange for currencies to be traded immediately. Forward Exchange Rate:  The rate of exchange for currencies specified in forward currency contracts. Forward Currency Contracts:  Agreements to deliver a unit of a nation’s currency in exchange for another at a specified price on a given date.

Copyright © 2004 South-Western. All rights reserved.11–8 Covered Interest Parity Covered Interest Parity:  A prediction that the interest rate on one nation’s bond will approximately equal the interest rate on another nation’s bond plus the forward premium, or the difference between the forward exchange rate and the spot exchange rate divided by the forward exchange rate.

Copyright © 2004 South-Western. All rights reserved.11–9 Uncovered Interest Parity Uncovered Interest Parity:  A prediction that the interest rate on a bond denominated in a currency that is expected to depreciate must exceed another nation’s bond rate by the rate at which the currency is expected to depreciate plus a risk premium.

Copyright © 2004 South-Western. All rights reserved.11–10 Foreign Exchange Market Efficiency Foreign Exchange Market Efficiency:  A situation in which the equilibrium spot and forward exchange rates imply a forward premium that is equal to the expected rate of currency depreciation plus any risk premium.

Copyright © 2004 South-Western. All rights reserved.11–11 Figure 11–2 The Effects of Correctly Anticipated Policy Actions

Copyright © 2004 South-Western. All rights reserved.11–12 Figure 11–3 The Effects of Completely Unanticipated Policy Actions

Copyright © 2004 South-Western. All rights reserved.11–13 Sources: Federal Reserve Bank of New York, Daily 10 A.M. Midpoint Foreign Exchange Rates from the New York Interbank Market, September 26, Table 11–1 Exchange Rates

Copyright © 2004 South-Western. All rights reserved.11–14 Figure 11–4 The Market for European Monetary Union Euros

Copyright © 2004 South-Western. All rights reserved.11–15 Source: Robert Flood and Andrew Rose, “Uncovered Interest Parity in Crisis: The Interest Rate Defense of the 1990s,” Center for Economic Policy Research Discussion Paper No. 2943, September Figure 11–5 Estimates of Excess Returns on International Bond Trading

Copyright © 2004 South-Western. All rights reserved.11–16 Interest-Rate Targets of Major Central Banks since 1993 Sources: Christopher Neely, “International Interest Rate Linkages,” Federal Reserve Bank of St. Louis International Economic Trends, August 2001; Bank of Canada, Bank of England, European Central Bank, and Board of Governors of the Federal Reserve System. Figure 11–6 Interest rate targets (in percent)