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Rational Expectations

Updated on April 17, 2024
Article byHarsh Katara
Reviewed byDheeraj Vaidya, CFA, FRM

What is Rational Expectations?

The rational expectations theory is a macroeconomics concept widely used modeling technique. This theory states that most common people’s decisions are based on three key factors: past experiences, the information available to them, and their human rationality. Further, this theory shall advise that individuals’ current economic expectations affect what the economy’s future state shall become.

What is Rational Expectations

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Rational expectations theory assumes that people act rationally and based upon three factors: experience, current mindset, and the information available to them, that decide the economy’s future. These are the future best guesses. This system ensures internal clarity in factors or systems with uncertainty. Moreover, the theory also places the impetus on outcomes not being too different in a systematic manner.

Key Takeaways

  • The rational expectations theory is a widely-used macroeconomic modeling technique stating that past experiences, available information, and rationality influence most people’s decisions.
  • Economic policies have implications on people’s expectations, which can affect their behavior and subsequent outcomes.
  • The effects of expansionary fiscal policies may differ depending on how individuals change their behavior in response to policy expectations.
  • The rational expectations theory can help policymakers make better-informed decisions by considering how people’s expectations may influence the outcome of economic policies.

Rational Expectations Explained

Rational expectations states that individuals make decisions based on their understanding of human psychology, available data, and their experiences in the past. However, it is also made clear that individuals can be wrong about these outcomes. That is, these outcomes can be different than their expectations.

The rational expectations theory has some explanations and versions, which can be strong or weak.

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

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Examples

Let us understand the rational expectations hypothesis in depth through the discussion below.

Rational Expectations

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  1. The Theory of Cobweb is Not Valid Always i.e.; Prices Become More Volatile: For example, high supply leads to lower costs, and when supply is cut off, prices increase. And again, supply increases 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: The stock market assumes that it captures all the relevant information while pricing it, including material nonpublic informationMaterial Nonpublic InformationMaterial Nonpublic Information, also known as the insider information is the information which is important but is not supposed to be disclosed to the public as the disclosure of the same has affect on the price or decision of investors’ of the company and this information is known only to authorized personnel of the company.read more.
  3. Permanent Income Hypothesis: Individuals judge whether the drop in their income level is permanent or temporary. They also consider future income and make consumption decisions based on that.

Implications

The implications of the rational expectations hypothesis can be different depending upon what people assume. However, let us understand common threads amidst these assumptions through the explanation below.

The implications of rational expectations can be different depending upon what people assume. 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 decided to use the quantitative easingQuantitative EasingQuantitative easing (QE) is an advanced monetary policy of central banks to stimulate growth in a stagnant economy by large scale buying of government bonds and other assets.read more program to revive the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. Due to this, there was a reduction rate of interest for more than seven years, and the implication per theory is that individuals, began to perceive that interest rates shall remain low.

Criticism

Like any other theory or hypothesis, the rational expectations theory is subject to its share of criticisms. Let us understand them to fully understand this concept.

  1. Present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more bias states that the individual’s current value on short-term income is more than income in a longer period.
  2. Most individuals are unaware of the impact of policies on the economy. For example, inflation impacts the economy.
  3. Most individuals do not learn from their past mistakes, i.e., if certain stocks performed well in the past, people keep buying them even though fundamentally it is no longer viable to purchase.
  4. A couple of economicsEconomicsEconomics is an area of social science that studies the production, distribution, and consumption of limited resources within a society.read more theories suggest that people mostly act irrationally.
  5. Asset bubbles, for example, a recent hike in bitcoinBitcoinBitcoin is a digital currency that came into existence in January 2009, speculated to be created by Satoshi Nakamato, whose true identity is yet to be authenticated. It provides lower transaction fees than the traditional online payment systems, is controlled by the decentralized authority, and is not like government-issued currencies.read more values. Then, after a long ride, it started falling.

Importance

The rational expectations theory suggests that individuals act incorrectly at certain times. Then, on average, these individuals can be correct to learn from previous errors.

The economic policy also has implications due to the rational expectations theory. For example, the impact of fiscal policy Fiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more, which is expansionary, shall not be the same if individuals change their behavior due to their expectations on the policy that is certain to have an outcome.

Challenges of Rational Expectations

For a theory with such elaborate measures and methodologies, it is obvious to have challenges and hurdles to calculating it. Let us learn about them through the points below.

  • It incorporates a lot of factors in decision-making.
  • After considering all the relevant information, all people and individuals need to be rational and act upon it.
  • People need to behave per the expectations of the policies placed by the government.

Rational Expectations vs. Adaptive Expectations

In a world where each individual has their set of expectations from situations, people, and other uncontrollable, it is inevitable that they might follow a certain checklist to ascertain them. These two types of expectations are often discussed together. However, their differences lie in their basics. Let us understand them through the discussion below.

The individuals using adaptive decision-makers use previous events and trends to predict future outcomes. At the same time, rational decision-making individuals shall use the best information available in the market to make the best decisions. It is also called backward-based thinking decision making.

In adaptive theory, people adapt to previous and past events. In rational expectations theory, people will not make decisions until they have gathered all relevant information.

Frequently Asked Questions (FAQs)

1. What is the idea of rational expectation, according to Robert Lucas?

According to Robert Lucas, the idea of rational expectations is that individuals make decisions based on their future expectations. These expectations are formed using all available information, including past experiences and knowledge of economic policies. Rational expectations theory assumes that individuals are rational and forward-looking, meaning that they use all available information to make the best decisions possible.

2. What are rational expectations in the New Keynesian model?

In the New Keynesian model, rational expectations refer to individuals forming expectations about future economic conditions based on all available information and economic theory. This means that individuals use their knowledge of the economy and economic policies to form expectations about future inflation, output, and other economic variables. 

3. What are the assumptions of rational expectations theory?

The assumptions of rational expectations theory include the assumptions of perfect foresight, which means that individuals have access to all available information and use it to form their expectations; rationality, which means that individuals make the best decisions possible given the available information; and consistency, which means that expectations are consistent with the underlying economic model. 

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