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In economics, "rational expectations" are model-consistent expectations, in that agents inside the model on average assume the model's predictions are valid. Rational expectations ensure internal consistency in aggregate stochastic models. To obtain consistency within a model, the predictions of the future value of economically relevant variables are optimal given the decision-makers' information set and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models. Rational expectations does not imply individual rationality and should not be confused with rational choice theory, which is used extensively in, among others, game theory.
Since most macroeconomic models today study decisions over many periods, the expectations of workers, consumers and firms about future economic conditions are an essential part of the model. How to model these expectations has long been controversial, and it is well known that the macroeconomic predictions of the model may differ depending on the assumptions made about expectations (see Cobweb model). To assume rational expectations is to assume that agents' expectations may be wrong, but are correct on average over time. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased and use all relevant information in forming expectations of economic variables.
This way of modeling expectations was originally proposed by John F. Muth (1961) and later became influential when it was used by Robert Lucas, Jr. and others. Modeling expectations is crucial in all models which study how a large number of individuals, firms and organizations make choices under uncertainty. For example, negotiations between workers and firms will be influenced by the expected level of inflation, and the value of a share of stock is dependent on the expected future income from that stock.
Deirdre McCloskey emphasized that "rational expectations" is an expression of intellectual modesty: "Muth's notion was that the professors [of economics], even if correct in their model of man, could do no better in predicting than could the hog farmer or steelmaker or insurance company. The notion is one of intellectual modesty. The common sense is "rationality": therefore Muth called the argument "rational expectations"."
Theory: Common sense version
Rational expectations theory defines this kind of expectations as being identical to the best guess of the future (the optimal forecast) that uses all available information. Thus, it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. As a result, rational expectations do not differ systematically or predictably from equilibrium results. That is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random. In an economic model, this is typically modelled by assuming that the expected value of a variable is equal to the expected value predicted by the model.
For example, suppose that P is the equilibrium price in a simple market, determined by supply and demand. The theory of rational expectations says that the actual price will only deviate from the expectation if there is an 'information shock' caused by information unforeseeable at the time expectations were formed. In other words, ex ante the price is anticipated to equal its rational expectation:
where is the rational expectation and is the random error term, which has an expected value of zero, and is independent of .
Rational expectations theories were developed in response to perceived flaws in theories based on adaptive expectations. Under adaptive expectations, expectations of the future value of an economic variable are based on past values. For example, people would be assumed to predict inflation by looking at inflation last year and in previous years. Under adaptive expectations, if the economy suffers from constantly rising inflation rates (perhaps due to government policies), people would be assumed to always underestimate inflation. Many economists have regarded this as unrealistic, believing that rational individuals would sooner or later realize the trend and take it into account in forming their expectations.
The hypothesis of rational expectations addresses this criticism by assuming that individuals take all available information into account in forming expectations. Though expectations may turn out incorrect, they will not deviate systematically from the realized values.
The rational expectations hypothesis has been used to support some strong conclusions about economic policymaking. An example is the Policy Ineffectiveness Proposition developed by Thomas Sargent and Neil Wallace. If the Federal Reserve attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly. This in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate, not employment. This is a distinctly New Classical outcome. During the 1970s rational expectations appeared to have made previous macroeconomic theory largely obsolete, which culminated with the Lucas critique. However, rational expectations theory has been widely adopted as a modelling assumption even outside of New Classical macroeconomics thanks to the work of New Keynesians such as Stanley Fischer. See f.e. Robert Skidelsky: The Return of the Master.
Of course, these economic policy consequences should be evaluated carefully. The relevance of this and other new classical theses is evident, but these theories should always be regarded as conditional statements. It means, for example, that the policy ineffectiveness hypothesis mentioned above is valid only under specific conditions, i.e. when the presumptions of the theory (such as perfect rationality or instant flexibility of prices) hold in reality. So new classical theorists could clearly specify the conditions under which traditional discretional economic policy can be effective again. If agents do not (or cannot) form rational expectations or if prices are not completely flexible, discretional and completely anticipated economic policy actions can trigger real changes.
Rational expectations theory is the basis for the efficient market theories. If a security's price does not reflect all the information about it, then there exist "unexploited profit opportunities": someone can buy (or sell) the security to make a profit, thus driving the price toward equilibrium. In the strongest versions of these theories, where all profit opportunities have been exploited, all prices in financial markets are correct and reflect market fundamentals (such as future streams of profits and dividends). Each financial investment is as good as any other, while a security's price reflects all information about its intrinsic value.
Theory: Experts' version
The Rational Expectations Hypothesis is about endogenous expectation formation, not exogenous. Endogenous expectation formation means that the expectations are modeled and disseminated, contrary to expectations that are formed by the holders of them. The modeling is done by economists, and the expectations are disseminated using communications technology. Keynes held expectations as exogenous, but monetarists like Friedman and his followers hold expectations endogenous. The ingenuity of endogenous expectations is that it makes possible to control human behavior using induced expectations, since ideas about future events affect current behavior. This is the idea in Carnegie decision making model and Rational Expectations. Different expectations mean different kind of futures. The Certainty Equivalence approach operates this way ignoring and adding uncertainty. See f.e. Soros, George: The Crisis of Global Capitalism: Open Society Endangered, for a short notion about this principle.
Selecting the expectations held by individuals mean choosing between alternative futures. Alan A. Walters uses the concept of Consistent Expectations instead of Rational Expectations, because consistency describes better model-consistent expectations than rationality. Rational Expectations can be totally irrational for the holder of them. This is the idea when Francis Fukuyama claims that it is possible for a human being to fail in surviving. Rational Expectations, that is Consistent Expectations Hypothesis, operates on a biopolitical basis since according to David Hume a human being can not be without expecting. This is not the only level of biopolitics, since newer mechanisms use electrical and medical means. So there is a kind of back-up when the Rational Expectations model fail to work. An interesting detail is that John Muth translates "choris syndesi", "without link".
Franco Modigliani has used the concept of full-blown rational expectations. The consistency instead of rationality notion means that the claims behind the modeled expectations do not have to be true. See Soros, George: The Crisis of Global Capitalism: Open Society Endangered, for a notion about about Rational Expectations, the expansion of the thinking, analysis of Karl Popper's legacy, and a notion about random walk. The Rational Expectations economy uses "superimposed" noise to create an illusion of random walk, shown in a paper connected to name John F. Muth.
- Adaptive expectations
- Behavioral economics
- Dynamic stochastic general equilibrium
- Factors of production
- Game theory
- Market price
- Lucas aggregate supply function
- Lucas critique
- Lucas island model
- Snowdon, B., Vane, H., & Wynarczyk, P. (1994). A modern guide to macroeconomics. (pp. 236–79). Cambridge: Edward Elgar Publishing Limited.
- Muth, John F. (1961). "Rational Expectations and the Theory of Price Movements" (PDF). Econometrica. 29 (3): 315–335. doi:10.2307/1909635. reprinted in Hoover, Kevin D., ed. (1992). The New Classical Macroeconomics, Volume 1. International Library of Critical Writings in Economics, vol. 19. Aldershot, Hants, England: Elgar. pp. 3–23. ISBN 978-1-85278-572-7.
- McCloskey, Deirdre N. (1998). The Rhetoric of Economics (2 ed.). Univ of Wisconsin Press. p. 53. ISBN 978-0-299-15814-9.
- Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.
- Begg, David: The Rational Expectations Revolution: Theories and Evidence.
- Fukuyama, Francis: The End of History and the Last Man
- Hanish C. Lodhia (2005) "The Irrationality of Rational Expectations – An Exploration into Economic Fallacy". 1st Edition, Warwick University Press, UK.
- Maarten C. W. Janssen (1993) "Microfoundations: A Critical Inquiry". Routledge.
- John F. Muth (1961) "Rational Expectations and the Theory of Price Movements" reprinted in The new classical macroeconomics. Volume 1. (1992): 3–23 (International Library of Critical Writings in Economics, vol. 19. Aldershot, UK: Elgar.)
- Thomas J. Sargent (1987). "Rational expectations," The New Palgrave: A Dictionary of Economics, v. 4, pp. 76–79.
- N.E. Savin (1987). "Rational expectations: econometric implications," The New Palgrave: A Dictionary of Economics, v. 4, pp. 79–85.
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