also: List of Economic Topics
EXPECTATIONS - macroeconomics
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.
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
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:
= P* + e
e is the random error term. On average, it equals zero. e is also independent
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.
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.
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
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
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."
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.
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.
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."
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.
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.
have made similar arguments, claiming that the entire "rational expectation"
theory was originated by Thomas Hobbes.
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.
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.
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.)
article (http://www.econlib.org/library/Enc/RationalExpectations.html) by Thomas
Sargent in the Economics Encyclopedia.