See also: List of Economic Topics

RATIONAL EXPECTATIONS - macroeconomics

Rational expectations is a theory in economics used to model the determination of expectations of future events by economic actors, originally proposed by John F. Muth (1961). 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.

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 Arie

For example, suppose that P* is the equilibrium price in a simple market, determined by supply and demand. Then, the theory of rational expectations says that the expected price (Pe) would equal:

Pe = P* + e

where e is the random error term. On average, it equals zero. e is also 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.

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 controversial conclusions for economic policymaking. For example, if the Central Bank decides to lower the unemployment rate by putting more money into the economy (an expansionary monetary policy), one interpretation of the rational expectations hypothesis (that of Robert Lucas) says that the policy will be ineffective. People will see what the Central Bank is doing and raise their expectations of future inflation. This in turn will counteract the expansionary effect of the increased money supply. All that the Central Bank can do is to raise the inflation rate, with at most temporary decreases in unemployment.

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 profit streams). Each financial investment is as good as any other, while a security's price reflects all information about its intrinsic value.

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."

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 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 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."

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.

Sociologists tend to criticize the theory based on 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 Allison specifically attacked the rational expectations theory.

Philosophers have made similar arguments, claiming that the entire "rational expectation" theory was originated by Thomas Hobbes.

Nowadays, economists are typically eclectic. They 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. Those studying financial markets similarly apply the efficient markets hypothesis but keep the existence of exceptions in mind.

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.

References

Muth, John F. (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, U.K.: Elgar.)

An article (http://www.econlib.org/library/Enc/RationalExpectations.html) by Thomas Sargent in the Economics Encyclopedia.