Everything about Rational Expectations totally explained
Rational expectations is an assumption used in many contemporary
macroeconomic models. Since most such models study decisions over many periods, the expectations of workers, consumers, and firms about future economic conditions are an essential part of the model. How to model these expectations has long been controversial, and it's well known that the macroeconomic predictions of the model may differ depending on the assumptions made about expectations (see
Cobweb model). To assume rational expectations is to assume that
agents' expectations are correct on average. In other words, although the future isn't fully predictable, agents' expectations are assumed not to be systematically
biased and use all relevant information in forming expectations of economic variables.
This way of modeling expectations was originally proposed by
John F. Muth (1961) and later became influential when it was used by
Robert E. Lucas Jr and others. Modeling expectations is crucial in theories like
new classical macroeconomics,
new Keynesian macroeconomics, and the
efficient market hypothesis of contemporary finance, which study the dynamics of the economy over time. For example, negotiations between workers and firms 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 this kind 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's assumed that outcomes that are being forecast don't differ systematically from the market
equilibrium results. As a result, rational expectations don't differ systematically or predictably from equilibrium results. That is, it assumes that people don't 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.
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 actual price will only deviate from the expectation if there's an 'information shock' caused by information unforeseeable at the time expectations were formed. In other words ex ante the actual price is equal to its rational expectation.:
» ::
P =
P* +
e
» ::
E(P) =
P*
where P* is the rational expectation and
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.
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, they won't 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.
Rational expectations theory is the basis for the
efficient market hypothesis (efficient market theory). If a security's price doesn't 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.
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's accurate but because it's 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's more than one possible equilibrium at any time then the more interesting implications of the theory of rational expectations don't apply. In fact, expectations would determine the nature of the equilibrium attained, reversing the line of causation posited by rational expectations theorists.
A further problem relates to the application of the rational expectations hypothesis to aggregate behavior. It is well known that assumptions about individual behavior don't carry over to aggregate behavior (
Sonnenschein-Mantel-Debreu theorem). The same holds true for rationality assumptions: Even if all individuals have rational expectations, the representative household describing these behaviors may exhibit behavior that doesn't satisfy rationality assumptions (Janssen 1993). Hence the rational expectations hypothesis, as applied to the representative household, is unrelated to the presence or absence of rational expectations on the micro level and lacks, in this sense, a microeconomic foundation.
It can be argued that it's difficult to apply the standard
efficient market hypothesis (efficient market 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.)
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.
Philosophers have made similar arguments, claiming that the entire "rational expectation" theory was originated by
Thomas Hobbes.
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's seen as "credible,"
for example, if it convinces people that it'll "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.
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.
Further Information
Get more info on 'Rational Expectations'.
|
External Link Exchanges
Do you know how hard it is to get a link from a large encyclopaedia? Well we're different and will prove it. To get a link from us just add the following HTML to your site on a relevant page:
<a href="http://rational_expectations.totallyexplained.com">Rational expectations Totally Explained</a>
Then simply click through this link from your web page. Our crawlers will verify your link, extract the title of your web page and instantly add a link back to it. If you like you can remove the words Totally Explained and embed the link in article text.
As long as your link remains in place, we'll keep our link to you right here. Please play fair - our crawlers are watching. Your site must be closely related to this one's topic. Any kind of spamming, dubious practises or removing the link will result in your link from us being dropped and, potentially, your whole site being banned. |
