Rational Expectations

Definition

Rational expectations is an economic theory that states that economic agents (such as consumers and firms) make decisions based on their best guess of the future, using all available information. This means that people's expectations about the future are not systematically biased, and they use the information they have as efficiently as possible when making decisions.

5 Must Know Facts For Your Next Test

1. Rational expectations theory was developed by economists such as John Muth and Robert Lucas, and has become a central concept in modern macroeconomics.
2. The rational expectations hypothesis assumes that economic agents use all available information to form their expectations about the future, and that these expectations are unbiased.
3. Rational expectations theory has important implications for the effectiveness of monetary and fiscal policy, as it suggests that people will adjust their behavior in response to expected policy changes.
4. The rational expectations hypothesis is a key component of the neoclassical synthesis, which combines Keynesian and neoclassical economic principles.
5. Rational expectations theory has been used to explain the phenomenon of the Phillips curve, which describes the relationship between inflation and unemployment.

Review Questions

• Explain how the rational expectations hypothesis relates to the building of a model of aggregate demand and aggregate supply.
  • The rational expectations hypothesis is a key component of the neoclassical analysis of aggregate demand and aggregate supply. According to the rational expectations theory, economic agents (such as consumers and firms) use all available information to form their expectations about the future, including their expectations about macroeconomic variables like inflation, output, and employment. These expectations then influence their current decisions, which in turn affect the aggregate demand and aggregate supply curves. For example, if people expect higher inflation in the future, they may increase their current spending, leading to a shift in the aggregate demand curve.
• Describe how the rational expectations hypothesis relates to the Phillips curve and the policy implications of the neoclassical perspective.
  • The rational expectations hypothesis has important implications for the Phillips curve and the policy implications of the neoclassical perspective. The traditional Phillips curve posits an inverse relationship between inflation and unemployment, suggesting that policymakers can use monetary or fiscal policy to influence this tradeoff. However, the expectations-augmented Phillips curve, which incorporates the rational expectations hypothesis, suggests that this tradeoff may not be stable over time. If economic agents form their expectations rationally, they will anticipate the effects of policy changes and adjust their behavior accordingly, potentially undermining the effectiveness of discretionary policy. This is a key tenet of the neoclassical perspective, which emphasizes the importance of credible, rule-based policies over discretionary interventions.
• Analyze how the rational expectations hypothesis relates to the practical problems with discretionary fiscal policy, and how it contributes to balancing Keynesian and neoclassical models.
  • The rational expectations hypothesis has important implications for the practical problems with discretionary fiscal policy and the need to balance Keynesian and neoclassical models. If economic agents form their expectations rationally, they will anticipate the effects of discretionary fiscal policy changes and adjust their behavior accordingly, potentially undermining the effectiveness of these policies. This is because rational agents will incorporate their expectations of future policy actions into their current decisions, leading to offsetting changes in private spending and investment. As a result, discretionary fiscal policy may be less effective than predicted by traditional Keynesian models, which assume that agents have static or adaptive expectations. To address this, policymakers have increasingly emphasized the importance of rule-based, credible policies over discretionary interventions, which is a key tenet of the neoclassical perspective. Balancing these Keynesian and neoclassical approaches is crucial for developing effective economic policies that account for the role of rational expectations.

Related terms

Adaptive Expectations: Adaptive expectations is a theory that assumes economic agents base their expectations of the future on past experience and trends, rather than using all available information.

Efficient Market Hypothesis: The efficient market hypothesis states that asset prices fully reflect all available information, and that it is impossible to consistently outperform the market.

Expectations-Augmented Phillips Curve: The expectations-augmented Phillips curve incorporates the role of expectations in determining the relationship between inflation and unemployment.