Rational expectations is a theory in economics originally proposed by John F. Muth (1961) and later developed by Robert E. Lucas Jr. It is used to model how economic agents forecast future events. Modeling expectations is of central importance in economic models, especially those of new classical macroeconomics, new Keynesian macroeconomics, and finance. For example, a firm's decision on the level of wages to set in the coming year 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. Face-to-face trading interactions on the New York Stock Exchange trading floor. ... John F. Muth (born 1930) is an American economist. ... Robert Emerson Lucas, Jr. ... New Classical Economics emerged as a school in Macroeconomics during the 1970s. ... New Keynesian economics developed partly in response to new classical economics. ... In finance, the efficient market hypothesis (EMH) asserts that financial markets are informationally efficient, or that prices on traded assets, e. ...

Theory

Rational expectations theory defines these kinds of expectations as being identical to the best guess of the future (the optimal forecast) that uses all available information. However, without further assumptions, this theory of expectations determination makes no predictions about human behavior and is empty. 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 value predicted by the model, plus a random error term representing the role of ignorance and mistakes. Price of market balance In economics, economic equilibrium is simply a state of the world where economic forces are balanced and in the abscence of external shocks the (equilibrium) values of economic variables will not change. ...

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 price expected now in the next period (E(P)) is given by: The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). ...

E(P) = P* + e

where e is the random error term, which has an expected value of zero, and is independent of P*.

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. This may be regarded as unrealistic - surely rational individuals would sooner or later realise the trend and take it into account in forming their expectations? Further, models of adaptive expectations never attain equilibrium, instead only moving toward it asymptotically. In economics, adaptive expectations means that people base their expectations of what will happen in the future based on what has happened in the past. ...

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, the deviations 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 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 throughout modern macroeconomics as a modelling assumption thanks to the work of New Keynesians such as Stanley Fischer. The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations. ... Thomas J. Sargent (born July 19th, 1943) is an economist. ... Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. ... According to the Lucas Critique, prediction based on historical data would be invalid if some policy change alters the relationship between relevant variables (such as private agents rational expectations of inflation). ... Stanley Fischer, Governor of the Bank of Israel Stanley Fischer (Hebrew: סטנלי פישר) is an economist and the current Governor of the Bank of Israel. ...

Rational expectations theory is the basis for the efficient market hypothesis and efficient markets 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 (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. In finance, the efficient market hypothesis (EMH) asserts that financial markets are informationally efficient, or that prices on traded assets, e. ... Efficient markets theory is a field of economics which seeks to explain the workings of capital markets such as the stock market. ... Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. ...

Criticisms

The hypothesis is often criticised as an unrealistic model of how expectations are formed. First, truly rational expectations would take into account the fact that information about the future is costly. The "optimal forecast" may be the best not because it is accurate but because it is too expensive to attain even close to accuracy. Followers of John Maynard Keynes go further, pointing to the fundamental uncertainty about what will happen in the future. That is, the future cannot be predicted, so that no expectations can be truly "rational." John Maynard Keynes (right) and Harry Dexter White at the Bretton Woods Conference John Maynard Keynes, 1st Baron Keynes, CB (pronounced cains, IPA ) (5 June 1883 – 21 April 1946) was a British economist whose ideas, called Keynesian economics, had a major impact on modern economic and political theory as well...

Further, the models of Muth and Lucas (and the strongest version of the efficient markets 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" level (potential output) -- corresponding to a unique NAIRU or natural rate of unemployment. 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. In economics, full employment has more than one meaning. ... In economics, potential output (also referred to as natural real gross domestic product) refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. ... The term NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment. ... -1...

In many cases, working people and business executives are unable to act on their expectations of the future. For example, they may lack the bargaining power to raise nominal wages or prices. Alternatively, wages or prices may have been set in the past by contracts that cannot easily be broken. (In sum, the setting of wages and the prices of goods and services is not as simple or as flexible as in financial markets.) This means that even if they have rational expectations, wages and prices are set as if people had adaptive expectations, slowly adjusting to economic conditions. This changes the behavior of the economy, so that those with rational expectations who can vary their prices without cost rationally expect that the economy acts following adaptive expectations and thus largely embrace adaptive expectations themselves. In economics, adaptive expectations means that people base their expectations of what will happen in the future based on what has happened in the past. ...

In financial markets, prices are much more flexible. However, the efficient-market hypothesis does not apply exactly. Though it is very difficult if not impossible to regularly "beat" the market and prices do seem to follow a random walk (as suggested by the hypothesis), financial asset prices reflect more than simply the "fundamentals." For example, market participants pay attention to each other, how others value stocks and bonds. John Maynard Keynes likened the stock market to a situation where people bet on a beauty contest. People don't bet on the "beauty" of the contestants (i.e., the fundamentals) as much as who everyone else thinks is most "beautiful." Thus, there is the possibility of a "bubble" in which everyone bets that asset prices will rise, causing them to rise (a self-fulfilling prophecy). Then, Keynes noted, the market becomes like the British game of "snap" (or the American "musical chairs"): no-one wants to lose by getting out of the game early or late (before or after prices reach their peak). Then, everyone tries to leave at once; there's a financial downturn, "panic," or crash. A virtuous circle of the "bull market" becomes a vicious one of the "bear market." John Maynard Keynes (right) and Harry Dexter White at the Bretton Woods Conference John Maynard Keynes, 1st Baron Keynes, CB (pronounced cains, IPA ) (5 June 1883 – 21 April 1946) was a British economist whose ideas, called Keynesian economics, had a major impact on modern economic and political theory as well... Currier & Ives print on economic bubbles, 1875. ... This article or section needs copy editing for grammar, style, cohesion, tone and/or spelling. ... Panic is the primal urge to run and hide in the face of imminent disaster. ... In many parts of economics there is an assumption that a complex system of determinants will tend to lead to a state of equilibrium. ... A bull market is a prolonged period of time when prices are rising in a financial market faster than their historical average. ... Vicious Circle is an album released in 1995 by L.A. Guns. ... A bear market is a prolonged period of time when prices are falling in a financial market. ...

It can be argued that it is difficult to apply the standard efficient-market hypothesis or efficient-markets theory to understand the stock market bubble that ended in 2000 and collapsed thereafter. (Advocates of Rational Expectations may say that the problem of ascertaining all the pertinent effects of the stock-market crash is a great challenge.) In finance, the efficient market hypothesis (EMH) asserts that financial markets are informationally efficient, or that prices on traded assets, e. ... Efficient markets theory is a field of economics which seeks to explain the workings of capital markets such as the stock market. ...

Sociologists tend to criticize the theory based on philosopher Karl Popper's theory of falsification. They note that many economists, upon being confronted with empirical data that goes against the "rational" theory, can simply modify their theories without ever touching the basic thesis of rational expectation. Furthermore, social scientists in general criticize the movement of this theory into other fields such as political science. In his book Essence of Decision, political scientist Graham T. Allison specifically attacked the rational expectations theory. This article provides a list of noted sociologists and major contributors to sociology (even if they did not primarily work as sociologists): Contents: Top - A B C D E F G H I J K L M N O P Q R S T U V W X Y Z... Sir Karl Raimund Popper, CH, FRS, FBA, (July 28, 1902 – September 17, 1994), was an Austrian born naturalized British[1] philosopher and a professor at the London School of Economics. ... Falsification may mean: The act of disproving a proposition, hypothesis, or theory. ... A central concept in science and the scientific method is that all evidence must be empirical, or empirically based, that is, dependent on evidence or consequences that are observable by the senses. ... Terms like SOSE (Studies of Society & the Environment) not only refer to social sciences but also studies of the environment. ... The Politics series Politics Portal This box:      Political Science is the field concerning the theory and practice of politics and the description and analysis of political systems and political behaviour. ... Essence of Decision: Explaining the Cuban Missile Crisis is an analysis, by political scientist Graham T. Allison, of the Cuban Missile Crisis. ... Graham T. Allison is a professor at Harvard University. ...

Philosophers have made similar arguments, claiming that the entire "rational expectation" theory was originated by Thomas Hobbes. A philosopher is a person devoted to studying and producing results in philosophy. ... “Hobbes” redirects here. ...

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

A specific field of economics, called behavioral economics, has emerged from those considerations, of which Daniel Kahneman (Nobel prize 2002) is one of the pioneers and main theorist. Nobel Prize in Economics winner Daniel Kahneman, was an important figure in the development of behavioral finance and economics and continues to write extensively in the field. ... Daniel Kahneman Daniel Kahneman (born March 5, 1934 in Tel Aviv, in the then British Mandate of Palestine, now in Israel), is a key pioneer and theorist of behavioral finance, which integrates economics and cognitive science to explain seemingly irrational risk management behavior in human beings. ...

See also

• Adaptive expectations

In economics, adaptive expectations means that people base their expectations of what will happen in the future based on what has happened in the past. ...

References

• Hanish C. Lodhia (2005) "The Irrationality of Rational Expectations - An Exploration into Economic Fallacy". 1st Edition, Warwick University Press, UK.
• 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 expectation," The New Palgrave: A Dictionary of Economics, v. 4, pp. 76-79.
• N.E. Savin (1987). "rational expeectation: econometric implications," The New Palgrave: A Dictionary of Economics, v. 4, pp. 79-85.

John F. Muth (born 1930) is an American economist. ... Thomas J. Sargent (born July 19, 1943) is an american economist specializaing in the fields of macroeconomics, monetary economics and time series economics. ...

External links

• An article by Thomas Sargent in the Economics Encyclopedia.