Rational expectations

Heterodox

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" as well as on average form the model's predictions as valid. Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the framework are assumed to be the same as that of the decision-makers in the model, condition their information set, the vintage of the random processes involved, as well as value example structure. The rational expectations precondition is used particularly in many contemporary macroeconomic models.

Since nearly macroeconomic models today examine decisions under uncertainty as well as over many periods, the expectations of individuals, firms, and government institutions approximately future economic conditions are an essential factor of the model. To assume rational expectations is to assume that agents' expectations may be wrong, but are adjustment on average over time. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased and collectively use all relevant information in forming expectations of economic variables. This way of modeling expectations was originally exposed by John F. Muth 1961 and later became influential when it was used by Robert Lucas Jr. in macroeconomics.

Deirdre McCloskey emphasizes that "rational expectations" is an expression of intellectual modesty:

Muth's theory was that the professors [of economics], even if right in their framework of man, could defecate no better in predicting than could the hog farmer or steelmaker or insurance company. The impression is one of intellectual modesty. The common sense is "rationality": therefore Muth called the argument "rational expectations".

Hence, it is for important to distinguish the rational-expectations assumption from assumptions of individual rationality and to note that the first does not imply the latter. Rational expectations is an assumption of aggregate consistency in dynamic models. In contrast, rational choice theory studies individual decision creating and is used extensively in, among others, game theory and contract theory. In fact, Muth cited survey data exhibiting "considerable cross-sectional differences of opinion" and was quite explicit in stating that his rational-expectations hypothesis does not assert... that predictions of entrepreneurs are perfect or that their expectations are all the same. In Muth's description of rational expectations, used to refer to every one of two or more people or matters individual holds beliefs that are model inconsistent, although the distribution of these diverse beliefs is unbiased relative to the data generated by the actions resulting from these expectations.

Implications

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 preceding years. Under adaptive expectations, whether the economy suffers from constantly rising inflation rates perhaps due to government policies, people would be assumed to always underestimate inflation. numerous 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 rational expectations hypothesis has been used to assistance some strong conclusions approximately economic policymaking. An example is the policy ineffectiveness proposition developed by Thomas Sargent and Neil Wallace. whether the Federal Reserve attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the conform of policy and raise their expectations of future inflation accordingly. This in vary will counteract the expansionary case of the increased money supply. any 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 offered previous macroeconomic theory largely obsolete, which culminated with the Lucas critique. However, rational expectations theory has been widely adopted and is considered an innocuous assumption in macroeconomics.

If agents do not or cannot form rational expectations or if prices are not totally flexible, discretional and totally anticipated economic policy actions can trigger real changes.