Rational expectations

Rational expectations is a set of modeling assumptions describing how macroeconomic agents form expectations about the future under uncertainty. Under these assumptions, agents are presumed to use all relevant and available information, making their expectations “model‑consistent”—that is, behaving as if they fully understand the structural model governing the macroeconomy.

History

The concept of rational expectations was first introduced by John F. Muth in his paper "Rational Expectations and the Theory of Price Movements" published in 1961. Robert Lucas and Thomas Sargent further developed the theory in the 1970s and 1980s which became seminal works on the topic and were widely used in microeconomics.

Significant Findings

Muth’s work introduces the concept of rational expectations and discusses its implications for economic theory. He argues that individuals are rational and use all available information to make unbiased, informed predictions about the future. This means that individuals do not make systematic errors in their predictions and that their predictions are not biased by past errors. Muth’s paper also discusses the implication of rational expectations for economic theory. One key implication is that government policies, such as changes in monetary or fiscal policy, may not be as effective if individuals’ expectations are not considered. For example, if individuals expect inflation to increase, they may anticipate that the central bank will raise interest rates to combat inflation, which could lead to higher borrowing costs and slower economic growth. Similarly, if individuals expect a recession, they may reduce their spending and investment, which could lead to a self-fulfilling prophecy.

Lucas’ paper “Expectations and the Neutrality of Money” expands on Muth's work and sheds light on the relationship between rational expectations and monetary policy. The paper argues that when individuals hold rational expectations, changes in the money supply do not have real effects on the economy and the neutrality of money holds. Lucas presents a theoretical model that incorporates rational expectations into an analysis of the effects of changes in the money supply. The model suggests that individuals adjust their expectations in response to changes in the money supply, which eliminates the effect on real variables such as output and employment. He argues that a stable monetary policy that is consistent with individuals' rational expectations will be more effective in promoting economic stability than attempts to manipulate the money supply.

In 1973, Thomas J Sargent published the article “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment”, which was an important contribution to the development and application of the concept of rational expectations in economic theory and policy. By assuming individuals are forward-looking and rational, Sargent argues that rational expectations can help explain fluctuations in key economic variables such as the real interest rate and the natural rate of employment. He also suggests that the concept of the natural rate of unemployment can be used to help policymakers set macroeconomic policy. This concept suggests that there is a trade-off between unemployment and inflation in the short run, but in the long run, the economy will return to the natural rate of unemployment, which is determined by structural factors such as the skills of the labour force and the efficiency of the labour market. Sargent argues that policymakers should take this concept into account when setting macroeconomic policy, as policies that try to push unemployment below the natural rate will only lead to higher inflation in the long run.

Theory

The key idea of rational expectations is that individuals make decisions based on all available information, including their own expectations about future events. This implies that individuals are rational and use all available information to make decisions. Another important idea is that individuals adjust their expectations in response to new information. In this way, individuals are assumed to be forward-looking and able to adapt to changing circumstances. They will learn from past trends and experiences to make their best guess of the future.

Criticism

While the rational expectations theory has been widely influential in macroeconomic analysis, it has also been subject to criticism:

Unrealistic assumptions: The theory implies that individuals are in a fixed point, where their expectations about aggregate economic variables on average are correct. This is unlikely to be the case, due to limited information available and human error.

Limited empirical support: While there is some evidence that individuals do incorporate expectations into their decision-making, it is unclear whether they do so in the way predicted by the rational expectations theory.

Inability to explain certain phenomena: The theory is also criticized for its inability to explain certain phenomena, such as 'irrational' bubbles and crashes in financial markets.

Notes

References

Hanish C. Lodhia (2005) "The Irrationality of Rational Expectations – An Exploration into Economic Fallacy". 1st Edition, Warwick University Press, UK.
Maarten C. W. Janssen (1993) "Microfoundations: A Critical Inquiry". Routledge.
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 expectations," The New Palgrave: A Dictionary of Economics, v. 4, pp. 76–79.
N.E. Savin (1987). "Rational expectations: econometric implications," The New Palgrave: A Dictionary of Economics, v. 4, pp. 79–85.