Rational Expectations

Rational expectations
The major innovation of new classical economics has been to introduce the principle of rational expectations into macroeconomics. In many areas of economics, particularly those involving investment and financial decisions, expectations are a central factor in decision making.
They influence how much businesses will spend on investment goods and whether consumers spend now or save for the future. For example, assume that you are considering how much to spend on your first house. Your decision will be affected by your expectations about future income, family size, and future housing prices.
How do people form their expectations? According to the rationalexpectations hypothesis, expectations are unbiased and based on all available information.
The use of expectations in economic theory is not new. Many earlier economists, including A. C. Pigou, John Maynard Keynes, and John R. Hicks, assigned a central role in the determination of the business cycle to peoples expectations about the future.
Keynes referred to this as waves of optimism and pessimism that helped determine the level of economic activity. But proponents of the rational expectations theory are more thorough in their analysis of expectations.
The influences between expectations and outcomes flow both ways. In forming their expectations, people try to forecast what will actually occur. They have strong incentives to use forecasting rules that work well because higher profits accrue to someone who acts on the basis of better forecasts, whether that someone is a trader in the stock market or someone considering the purchase of a new car.
And when people have to forecast a particular price over and over again, they tend to adjust their forecasting rules to eliminate avoidable errors. Thus, there is continual feedback from past outcomes to current expectations. Translation: in recurrent situations the way the future unfolds from the past tends to be stable, and people adjust their forecasts to conform to this stable pattern.
The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be. The concept is motivated by the same thinking that led Abraham Lincoln to assert, You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.
From the viewpoint of the rational expectations doctrine, Lincolns statement gets things right. It does not deny that people often make forecasting errors, but it does suggest that errors will not persistently occur on one side or the other.
Economists who believe in rational expectations base their belief on the standard economic assumption that people behave in ways that maximize their utility (their enjoyment of life) or profits. Economists have used the concept of rational expectations to understand a variety of situations in which speculation about the future is a crucial factor in determining current action.
Rational expectations is a building block for the random walk or efficient markets theory of securities prices, the theory of the dynamics of hyperinflations, the permanent income and life-cycle theories of consumption, and the design of economic stabilization policies.
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random.
An alternative formulation is that rational expectations are model-consistent expectations, in that the agents inside the model assume the model's predictions are valid.
The rational expectations assumption is used in many contemporary macroeconomic models, game theory and other applications of rational choice theory.
Since most macroeconomic models today 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 is 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 may be individually wrong, but are correct on average. In other words, although the future is not 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 all models which study how a large number of individuals, firms and organizations make choices under uncertainty.
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.
Theory
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.
Theory
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 expected value predicted by the model.
Theory
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 is an 'information shock' caused by information unforeseeable at the time expectations were formed.
Theory
In other words ex ante the actual price is equal to its rational expectation: P = P *+ E[P] = P * where P * is the rational expectation and 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 realize the trend and take it into account in forming their expectations?
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 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.
Rational expectations theory is the basis for the efficient market hypothesis (efficient market 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.
Criticisms
The models of Muth and Lucas (and the strongest version of the efficient-market 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.[citation needed]
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.
A further problem relates to the application of the rational expectations hypothesis to aggregate behavior. It is well known that assumptions about individual behavior do not carry over to aggregate behavior (SonnenscheinMantel-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 does not 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 is difficult to apply the standard efficient market hypothesis (efficient market theory) to understand the stock market bubble that ended in 2000 and collapsed thereafter; however, advocates of rational expectations say that the problem of ascertaining all the pertinent effects of the stock-market crash is a great challenge.
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.
Some economists now use the adaptive expectations model, but then complement it with ideas based on the rational expectations theory. For example, an antiinflation 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.
Expectational Error Models of the Business Cycle A long tradition in business cycle theory has held that errors in peoples forecasts are a major cause of business fluctuations. This view is embodied in the phillips curve (the observed inverse correlation between unemployment and inflation), with economists attributing the correlation to errors people make in their forecasts of the price level.
Expectational Error Models of the Business Cycle
Before the advent of rational expectations, economists often proposed to exploit or manipulate the publics forecasting errors in ways designed to generate better performance of the economy over the business cycle. Thus, Robert Hall aptly described the state of economic thinking in 1973 when he wrote:
The benefits of inflation derive from the use of expansionary policy to trick economic agents into behaving in socially preferable ways even though their behavior is not in their own interest.... The gap between actual and expected inflation measures the extent of the trickery.... The optimal policy is not nearly as expansionary [inflationary] when expectations adjust rapidly, and most of the effect of an inflationary policy is dissipated in costly anticipated inflation.
Rational expectations undermines the idea that policymakers can manipulate the economy by systematically making the public have false expectations. Robert Lucas showed that if expectations are rational, it simply is not possible for the government to manipulate those forecast errors in a predictable and reliable way for the very reason that the errors made by a rational forecaster are inherently unpredictable.
Lucass work led to what has sometimes been called the policy ineffectiveness proposition. If people have rational expectations, policies that try to manipulate the economy by inducing people into having false expectations may introduce more noise into the economy but cannot, on average, improve the economys performance.
Design of Macroeconomic Policies

The policy ineffectiveness result pertains only to those economic policies that have their effects solely by inducing forecast errors. Many government policies work by affecting margins or incentives, and the concept of rational expectations delivers no policy ineffectiveness result for such policies. In fact, the idea of rational expectations has been used extensively in such contexts to study the design of monetary, fiscal, and regulatory policies to promote good economic performance.

The idea of rational expectations has also been a workhorse in developing prescriptions for optimally choosing monetary policy. Truman Bewley and William A. Brock have been important contributors to this literature. Bewleys and Brocks work describes precisely the contexts in which an optimal monetary arrangement involves having the government pay interest on reserves at the market rate. Their work supports, clarifies, and extends proposals to monetary reform made by Milton Friedman in 1960 and 1968.
Rational expectations has been a working assumption in recent studies that try to explain how monetary and fiscal authorities can retain (or lose) good reputations for their conduct of policy. This literature has helped economists understand the multiplicity of government policy strategies followed, for example, in high-inflation and low-inflation countries.

In particular, work on reputational equilibria in macroeconomics by Robert Barro and by David Gordon and Nancy Stokey showed that the preferences of citizens and policymakers and the available production technologies and trading opportunities are not by themselves sufficient to determine whether a government will follow a low-inflation or a high-inflation policy mix. Instead, reputation remains an independent factor even after rational expectations have been assumed.

Rational Expectations

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Rational Expectations

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Rational expectations

Expectational Error Models of the Business Cycle

Expectational Error Models of the Business Cycle

Expectational Error Models of the Business Cycle

Expectational Error Models of the Business Cycle

Design of Macroeconomic Policies

Design of Macroeconomic Policies

Design of Macroeconomic Policies

Design of Macroeconomic Policies

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