Rational Expectations Theory - Definition

Updated at December 19th, 2020

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Rational Expectations Theory Definition

Rational expectations theory is an economic concept which asserts that individual agents do make decisions based on the markets available information and also learning from the previous trends. Based on this theory, there is an expectation that people would sometimes be wrong, but they can sometimes be right as well.

A Little More on What is Rational Expectations Theory

Note that as per this theory, economic behavior is based on various observations. That averagely, people are capable of predicting future conditions correctly and at the same time act on them. This is whether or not they understand the relationship of cause-and-effect that underlines both the events and their own way of thinking. In other words, their forecast is usually perfect in that the expectations which they tend to construct in a manner that is irrational happen to be correct in the end. However, in case of any emerging errors, it usually as a result of random and causes that cannot be foreseen. In addition, in those efficient markets where there is perfect information or nears perfect information, people anticipate the action of the government to either restrain or stimulate the economy. Following this, people will, therefore, embark on adjusting their response in that direction.

Background of Rational Expectations Theory

The idea of expectation in economics is not new and can be traced back to 1930s. John Maynard Keynes a famous economist from Britain decided to assign the future expectations of the people as a prime role when it comes to determining the cycle of the business. He referred to this as, the wave pessimism and optimism. However, the man who proposed the actual rational expectation theory is a famous economist known as John F. Muth. He applied the theory to try and describe various cases. He believed that there are scenarios where the outcomes in part, depend on what people expect to happen in the future. The rational expectation theory has the following assumptions:

Because of rational expectations, people are able to learn from previous mistakes.
People have an understanding of how government policies change macroeconomic variables as well as how the economy works.
Since predictions are unbiased, people use economic theories and all the information at their disposal to make decisions.

Generally, rational expectation theory comes two versions; strong and weak versions. Strong Version This version is of the assumption that actors have the ability to make rational decisions because they can access available information. The decisions they make are based on this information. Weak Version On the other hand, this version is of the assumption that people do make a decision based on their limited knowledge simply because, they lack time to get hold of all the information that they require.

How it Works [Example]

Example One Lets assume that the government tries to increase the supply of cash. In this case, people may also decide to raise their prices as well as wage demands. This is for the purpose of compensating the inflationary impact of the increase. Equally, when there is accelerated inflation, credit controls in the form of high-interest rates are expected. Example Two Agricultural commoditys price is highly dependent on the number of acres planted by farmers. This will then determine the price that farmers will expect when they finally harvest and sell their produce. Note that rational expectation does have an effect on economic policy. However, the expansionary fiscal policys impact will be different when peoples behavior happens to change. Note that the expansionary fiscal measures by the government cause an increase in inflation, then people will definitely put into consideration their future expectations. This is contrary to the belief that our decisions are influenced by government policies.

Rational Expectations Theory and Microeconomics

Macroeconomics uses the rational expectations concept. People possess rational expectations when it comes to economic variables. This implies that when people want to predict factors that are likely to affect their economic decisions, they will rely on the available information to do that. Generally, according to this theory, there is no bias when it comes to prediction as well as on the available information. This theory is of the idea that generally, people are capable of making unbiased predictions.

Rational Expectation Theory Application

There are many ways in which rational expectation theory can be used. They are as follows:

Rational expectation theory is currently being used by most macroeconomists as an assumption when analyzing their policies.
Also, people use this theory to examine inflations prediction accuracy.
The rational expectations theorys assumption is what economists use when they want to create macroeconomic principles.

Practical Implication of Rational Expectations Theory

Note that when economic stimulus is known in advance, they usually do not have any effect on the economy. For this reason, the rational expectation theory may not affect the actual output because of ineffective.

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