Rational expectations

Rational expectations

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Rational expectations is a hypothesis in economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random
White noise
White noise is a random signal with a flat power spectral density. In other words, the signal contains equal power within a fixed bandwidth at any center frequency...

. An alternative formulation is that rational expectations are model-consistent expectations, in that the agents inside the model assume the model's predictions are valid. The rational expectations assumption is used in many contemporary macroeconomic models, game theory
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

 and other applications of rational choice theory
Rational choice theory
Rational choice theory, also known as choice theory or rational action theory, is a framework for understanding and often formally modeling social and economic behavior. It is the main theoretical paradigm in the currently-dominant school of microeconomics...

.

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
Cobweb model
The cobweb model or cobweb theory is an economic model that explains why prices might be subject to periodic fluctuations in certain types of markets. It describes cyclical supply and demand in a market where the amount produced must be chosen before prices are observed. Producers' expectations...

). To assume rational expectations is to assume that agents
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....

' expectations may be individually wrong, but are correct on average. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased
Bias (statistics)
A statistic is biased if it is calculated in such a way that it is systematically different from the population parameter of interest. The following lists some types of, or aspects of, bias which should not be considered mutually exclusive:...

 and use all relevant information in forming expectations of economic variables.

This way of modeling expectations was originally proposed by John F. Muth
John Muth
-Legacy:It has hard to point to one substantial area of economic research into dynamic problems which has not changed as a result of the publication of Muth's works at GSIA. Almost paradoxically, the only viable alternative to Muth's hypothesis is the research agenda put forward by Herb Simon and...

 (1961) and later became influential when it was used by Robert E. 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, and the value of a share of stock is dependent on the expected future income from that stock.

Theory


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
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...

 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
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

. 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 actual price is equal to 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
Adaptive expectations
In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...

. 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. This may be regarded as unrealistic - surely 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 expected values.

The rational expectations hypothesis has been used to support some radical conclusions about economic policymaking. An example is the Policy Ineffectiveness Proposition
Policy Ineffectiveness Proposition
The Policy Ineffectiveness Proposition is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations...

 developed by Thomas Sargent and Neil Wallace
Neil Wallace
Neil Wallace is an American economist and professor at Pennsylvania State University. Wallace is considered one of the main proponents of new classical macroeconomics....

. If the Federal Reserve attempts to lower unemployment through expansionary monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 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
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

. However, rational expectations theory has been widely adopted throughout modern macroeconomics as a modelling assumption thanks to the work of New Keynesians such as Stanley Fischer
Stanley Fischer
Stanley "Stan" Fischer is an American-Israeli economist and the current Governor of the Bank of Israel. He previously served as Chief Economist at the World Bank.-Biography:...

.

Rational expectations theory is the basis for the efficient market hypothesis
Efficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

 (efficient market theory). 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
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...

 (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.

Criticisms


The models of Muth and Lucas (and the strongest version of the efficient-market hypothesis) assume that at any specific time, a market or the economy has only one equilibrium (which was determined ahead of time), so that people form their expectations around this unique equilibrium. Muth's math (sketched above) assumed that P* was unique. Lucas assumed that equilibrium corresponded to a unique "full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

" level (potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

) -- corresponding to a unique NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 or natural rate of unemployment
Natural rate of unemployment
The natural rate of unemployment is a concept of economic activity developed in particular by Milton Friedman and Edmund Phelps in the 1960s, both recipients of the Nobel prize in economics...

. If there is more than one possible equilibrium at any time then the more interesting implications of the theory of rational expectations do not apply. In fact, expectations would determine the nature of the equilibrium attained, reversing the line of causation posited by rational expectations theorists.

A further problem relates to the application of the rational expectations hypothesis to aggregate behavior. It is well known that assumptions about individual behavior do not carry over to aggregate behavior (Sonnenschein-Mantel-Debreu theorem
Sonnenschein-Mantel-Debreu Theorem
The Sonnenschein–Mantel–Debreu theorem is a result in general equilibrium economics. It states that the excess demand function for an economy is not restricted by the usual rationality restrictions on individual demands in the economy...

). The same holds true for rationality assumptions: Even if all individuals have rational expectations, the representative household describing these behaviors may exhibit behavior that does not satisfy rationality assumptions (Janssen 1993). Hence the rational expectations hypothesis, as applied to the representative household, is unrelated to the presence or absence of rational expectations on the micro level and lacks, in this sense, a microeconomic foundation.

It can be argued that it is difficult to apply the standard efficient market hypothesis
Efficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

 (efficient market theory) to understand the stock market bubble
Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....

 that ended in 2000 and collapsed thereafter; however, advocates of rational expectations say that the problem of ascertaining all the pertinent effects of the stock-market crash is a great challenge.

Furthermore, social scientists in general criticize the movement of this theory into other fields such as political science
Political science
Political Science is a social science discipline concerned with the study of the state, government and politics. Aristotle defined it as the study of the state. It deals extensively with the theory and practice of politics, and the analysis of political systems and political behavior...

. In his book Essence of Decision
Essence of Decision
Essence of Decision: Explaining the Cuban Missile Crisis is an analysis, by political scientist Graham T. Allison, of the Cuban Missile Crisis. Allison used the crisis as a case study for future studies into governmental decision-making. The book became the founding study of the John F...

,
political scientist Graham T. Allison
Graham T. Allison
Graham Tillett Allison, Jr. is an American political scientist and professor at the John F. Kennedy School of Government at Harvard. He is renowned for his contribution in the late 1960s and early 1970s to the bureaucratic analysis of decision making, especially during times of crisis...

 specifically attacked the rational expectations theory.

Some economists now use the adaptive expectations
Adaptive expectations
In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...

 model, but then complement it with ideas based on the rational expectations theory. For example, an anti-inflation campaign by the central bank is more effective if it is seen as "credible," i.e., if it convinces people that it will "stick to its guns." The bank can convince people to lower their inflationary expectations, which implies less of a feedback into the actual inflation rate. (An advocate of Rational Expectations would say, rather, that the pronouncements of central banks are facts that must be incorporated into one's forecast because central banks can act independently). Those studying financial markets similarly apply the efficient-markets hypothesis but keep the existence of exceptions in mind.

See also

  • Adaptive expectations
    Adaptive expectations
    In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...

  • Game theory
    Game theory
    Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

  • Dynamic stochastic general equilibrium
    Dynamic stochastic general equilibrium
    Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...

  • Rationality
    Rationality
    In philosophy, rationality is the exercise of reason. It is the manner in which people derive conclusions when considering things deliberately. It also refers to the conformity of one's beliefs with one's reasons for belief, or with one's actions with one's reasons for action...

  • Lucas critique
    Lucas critique
    The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

  • Lucas island model
  • Lucas aggregate supply function
    Lucas aggregate supply function
    The Lucas aggregate supply function or Lucas 'surprise' supply function, based on the Lucas imperfect information model, is a representation of aggregate supply based on the work of new classical economist Robert Lucas...


External links

  • Rational Expectations entry in the Concise Encyclopedia of Economics
    Concise Encyclopedia of Economics
    The Concise Encyclopedia of Economics is a widely-used encyclopedia of economics. It is used by students and teachers from high school to college to graduate school, and is one of the most popular worldwide resources for researching and understanding topics in economics.Articles are written by...

     written by Thomas Sargent
    Thomas J. Sargent
    Thomas John "Tom" Sargent is an American Nobel Memorial Prize in Economic Sciences winning economist, specializing in the fields of macroeconomics, monetary economics and time series econometrics...

    .