Rational Expectations

Rational Expectations Definition

The rational expectations theory is a macroeconomics concept and widely used modeling technique and this theory state that most of the common people will base their decisions on 3 key factors: their past experiences, the information available to them and their human rationality and further this theory shall advise that individual’s current economy expectations which are, themselves, and that they would be able to have an effect as to what the economy’s future state shall become.

Explanation

The rational expectations theory has some explanations, and it has some versions of the same, which can be strong and weak.

  • The “strong” version theory and explanation will assume that individuals will be able to access all the information that is available, and it shall make decisions that are rational, and those will be based on that information.
  • The “weak” version theory will assume that individuals actually lack time to process all the relevant information, but they will finalize or make decisions based on their knowledge, which would be limited.

Examples

Rational Expectations

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Source: Rational Expectations (wallstreetmojo.com)

  1. The Theory of Cobweb is Not Valid Always i.e.; prices become more volatile: For example, high supply leads to lower prices, and when supply is cut off, then prices increase, and again supply would increase, and this circle shall continue.
  2. Efficient Market HypothesisEfficient Market HypothesisThe efficient market hypothesis (EMH) states that the stock prices indicate all relevant information and are universally shared, making it impossible for investors to earn above-average returns consistently. Economist Eugene Fama gave the idea of the efficient market hypothesis in the 1960s.read more: Where it is assumed that the stock market captures all the relevant information while pricing the stock, including material nonpublic information.
  3. Permanent Income Hypothesis: Individuals judge whether the drop in their income level is permanent or temporary, and they also consider future income, and they make consumption decisions based on that.

Implications

The implications of rational expectations could be different depending upon what people assumed. For example, after the 2008 financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, the federal reserve actually decided to make use of the quantitative easingQuantitative EasingQuantitative easing (QE) refers to that non-standard monetary policy whereby the central bank makes an open market purchase of the long-term securities such as government bonds to induce additional money in the economy.read more program in order to revive the economy, and because of this, there was reduction rate of interest for around more than seven years and the implication per theory the individuals began to feel that interest rates shall remain low.

Criticism

There are many criticisms to this theory, and they are:

  1. Present value bias, which states that the individual’s present value on short term income is more than income in a longer period of time.
  2. Most of the individuals are unaware of the impact of policies of the economy; for example, inflation impacts the economy.
  3. Most of the individuals don’t learn from their past mistakes i.e., if certain stocks performed well in the past, people keep buying them even though the stock is no longer fundamentally viable to purchase.
  4. A couple of economics theories suggest that people mostly act irrationally.
  5. Asset bubbles, for example, a recent hike in bitcoin values, and after a long ride, it started falling.

Importance of Rational Expectations

This theory suggests that although individuals act incorrectly at certain times. On average, these individuals will be correct, and so as the individuals will learn from previous errors.

The economic policy also has implications due to the rational expectations theory. The impact of fiscal policyFiscal PolicyFiscal policy is a government policy that is used to control a country's finances and revenue, and it includes various taxes on goods, services, and individuals, i.e., revenue collection. It has an impact on spending levels, so it is referred to as monetary policy's sister policy.read more, which is expansionary, shall be not the same if individuals change their behavior due to their expectations on the policy, which is certain to have an outcome.

Rational Expectations vs. Adaptive Expectations

While individuals who use adaptive decision-makers use previous events and trends to predict the outcomes of the future while rational decision-making individuals shall use the best information which is available in the market so as to make the best decisions and this is also called backward based thinking decision making.

In adaptive theory, people adapt to previous and past events, and in rational expectations theory, people will not make decisions until all relevant information has been gathered by them.

Challenges of Rational Expectations

  • It incorporates a lot of factors in decision making.
  • All people and individuals need to be rational and have to act upon after taking all the relevant information into consideration.
  • People need to behave per expectations of the policies being in place by the government.

Conclusion

Rational expectations theory assumes that people act rationally and will be based upon three factors which are past experience, current mindset, and the information available to them, and this will decide the future of the economy. These are the future best guess.

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