Lucas-Phelps model Essay Example | Topics and Well Written Essays - 1000 words

Lucas-Phelps model - Essay Example Government’s interest in stabilising the economy is not only rooted on its political responsibility to control fluctuations in prices but equally to reign-in inflations that is brought about by temporary economic stressors as well. Ensuring the predictability of its economy will strengthen the job market and will also reinforce the collective confidence of the people to the government and its goals. Governments that are heavily involved in its country’s economic activity can, by its regular function, control interest rates that will restrict the liquidity of the market. By introducing temporary tax incentives however can create a situation that will lead to an excess supply of goods which circumstance will similarly bring down prices for that commodity. While enforcing stricter rules and regulation, the government can also influence the supply or the availability of goods in the market that will, in turn, force the prices of that commodity. These controls when implement ed on key economic indicator products such as oil or even wheat are effective tools in stabilising an economy. However, the end-results of these controls are not absolute due to the volatile nature of the economy. There are tangible variables that can be controlled through fiscal policies or through the degree in which laws are enforced but the collective consciousness of the market is very hard to control much less predict. The â€Å"rational expectation hypothesis† or â€Å"theory of rational expectation† posits that in uncertain conditions, the main players—composed of the people—in any economy make decisions based on their perceptions of how economic stressors will affect them (Muth, 1992). Meanwhile, economic agent’s rational expectations revolve around other market forces that would include government intervention, raw materials or input materials availability to create the best possible economic model for the future. Thus, the rational expec tation hypothesis propose that economic predictions based on the correlation of an infinite number of different variables are correct even if individual predictions made on the different variables turn out to be erroneous or inaccurate so long as the expected model holds. The primary reason why stabilisation policies are enforced or applied to a volatile market is to stabilise the economy, if not make it more predictable in order for economic agents to settle. However, if economic agents create an economic model base on the current economic values of economic stressors towards stabilising the economy, the introduction of a new variable from the government base on the â€Å"rational expectation hypothesis† will not make a huge impact. The primary reason for this is that over time, given that the economic agents also need to respond to the economic model they created the economy will eventually stabilise or settle. Cyclical Aggregate Demand Policy defines an economic systemâ₠¬â„¢s fluctuations as far as demands for goods are concerned. Counter cyclical or reversal of the economic system’s demand for goods to force it to follow a different path is not an absolute solution to stabilise prices in particular and stabilise the economy in general. This is especially accurate at full employment since the output of the work force will eventually find its way to mainstream market where its price is subject to market forces. The proposition that stabilisation policies are negated by rational expectati