Econ 123: Week 2

Rational Expectations Theory

• Developed by John Muth in 1961, emphasizing that individuals make decisions using all available information.
• Individuals adjust their expectations based on new information, leading to correct average expectations over time.
• Contrasts with the Keynesian view that assumed people often had systematic biases in their expectations.
• Influences macroeconomic principles, including reactions to monetary and fiscal policies.
• Integral in the formation of the New Classical Economics and Real Business Cycle Theory.

Modigliani-Miller Theorem

• Proposes that capital structure irrelevance means a firm's value is unaffected by whether it is financed through debt or equity.
• Argues the dividend policy is irrelevant to a firm's value; value is determined by earning power and investment decisions instead.
• Challenges traditional beliefs about optimal capital structure and dividend relevance.
• Highlights the importance of evaluating the cost of capital, which remains complex to calculate.

Efficient Market Hypothesis (EMH)

• Suggests that stock prices reflect all available information, making it difficult to outperform the market consistently.
• Supported by studies from UChicago showing that random selections of stocks yield similar returns to expert-driven portfolios.
• Michael Jensen's work indicates that mutual fund managers often fail to achieve risk-adjusted returns that surpass market performance.

Active vs Passive Investing

• Bogle's indexing strategy emphasizes that market returns are driven by economic fundamentals, making it hard to beat the market.
• Stresses the advantages of passive investing to minimize transaction costs.
• Paul Samuelson advocated for index funds, arguing they would outperform actively managed funds for small investors.

Corporate Governance and Regulation

• Questions whether corporate managers prioritize shareholder interests, given that they're managing other people's funds.
• Introduction of efficient markets theory suggests financial markets will optimize investment decisions and guide corporate behavior effectively.
• Jensen noted that strong incentives can align the interests of owners and managers in large public corporations.

Psychology in Economics

• Daniel Kahneman and Amos Tversky explored cognitive biases affecting decision-making.
• Common biases include:
  • Availability heuristic: Judging likelihood based on recall of similar events.
  • Representativeness heuristic: Assessing probabilities based on stereotypes.
  • Anchoring bias: Overreliance on initial information received.
  • Framing effect: Decisions influenced by how information is presented.
  • Loss aversion: Preference for avoiding losses over acquiring gains.
• Their research implies that while heuristics simplify decision-making, they can lead to significant, systematic errors.

This quiz explores the concepts of rational expectations as presented by John Muth. It discusses how individual and corporate predictions about the future converge with the predictions made by sophisticated economic models. Test your understanding of these theories in the context of Financial Economics.