The Rational Expectations Hypothesis as a Key Element of New Classical Macroeconomics

The following chapter offers a comprehensive analysis of the most cited theory of new classical macroeconomics that became a foundation of subsequent theoretical developments. The immediate objective of new classical theories to grasp the real world—something that makes this enquiry especially interesting—has made the confrontation of theory and reality inevitable. The ‘strong’ and ‘weak’ definition of the REH and the compatibility of these theories and the subsequent assumptions of unbiasedness and orthogonality are all thoroughly explored. In applying arguments from experimental economics, it is argued that the rational expectations hypothesis provided by new classical theories is a component of a pure theory, despite new classical ambitions to describe reality in its entirety. The core element of this chapter is that inflation targeting can be theorized successfully by the requisites and through a careful re-formulation of the REH. As it will be seen, the ‘strong’ definition does not make excessive claims on agents’ rationality if a central institution becomes incorporated in the models capable of anchoring public expectations.