According to the expectations hypothesis
, which lies at the centre of the benchmark finance model, interest rates on term bonds are determined by the expected sum of short-term interest rates over the life of the bond (equation 1).
Sargent using application of the rational expectations hypothesis
came to the conclusion that a coordinated monetary policy has no effect on the elimination of unemployment and production increase.
He believes in discretionary fiscal and monetary policies and in the rational expectations hypothesis
The rational expectations hypothesis
(REH) is a theoretically attractive framework for assessing the mechanism with which economic agents process information when formulating judgments about the real world (Krause 2000).
The topics discussed include rediscovering the macroeconomic roots of financial stability policy, inflation-indexed bonds and the expectations hypothesis
, the economics of credit default swaps, equilibrium in the initial public offering market, and carry trade and momentum in currency markets.
Tests of the rational expectations hypothesis
(REH) outside the experimental laboratory typically utilize two types of data: quantitative measures of expectations about publicly observed variables such as inflation, usually elicited from small samples of professional forecasters; and qualitative measures of expectations about privately observed variables such as personal income, elicited from large samples of households.
Another important theme of the book is that traditional methods of economic inquiry, such as the efficient market hypothesis and the rational expectations hypothesis
, are not well suited for analyzing financial bubbles.
From McCallum (2005), if the European Central Bank (ECB) smoothes the path for short-run interest rates, and if it weighs in the exchange rates when formulating policy, then simple tests of the expectations hypothesis
(EH) could be severely biased.
Now, the upward-sloping yield curve does signal rises in interest rates; the expectations hypothesis
is working; returns on long-term bonds will be no higher (on average) than those on short-term bonds.
This not only assumes the answer to the decomposition in equation 1, but it conflicts with an enormous body of work documenting the empirical weaknesses of the expectations hypothesis
Notable sufficient conditions for the pure expectations hypothesis
are that households be neutral to risk and the price level behave like a random walk; the pure Fisher equation requires only risk neutrality.
John Muth (1961) was the first to formulate the rational expectations hypothesis
in a precise way.