Rational Expectations Hypothesis. Rational expectations is states that, when making decisions, agents will form their decisions on the best available information and they will learn from past trends. This hypothesis suggests that people may occasionally make wrong decisions but, on average, they will make the correct decision.
There are two versions of the rational expectations hypothesis, the ‘weak’ and ‘strong’ version.
The ‘weak’ version of the rational expectations hypothesis posits that agents will make the best use of public information to form their expectations. For example, agents will listen to reports given by the central bank to help form their inflation expectations. Rational expectations does not mean perfect foresight. Agents will make errors because of incomplete information, but these errors are random and when agents make errors they learn from their errors and change the way their expectations are formed. What this means is that agents’ expectations of variables will, on average, equal their true value (Snowden et al 1994, p.190):
Muth (1961, pp.315-355) posits that because expectations are informed predictions of the future they are also predictions of economic theory. The ‘Muthian’ or ‘strong’ version of rational expectations suggests that agents’ expectations of variables will equal the mathematical conditional expectations of those variables:
Agents take into account all publicly available information and what they think is the ‘correct’ macro model of the economy to form their expectations.
Rational expectations has implications for both macro and micro policy. For example, if the government announce that they will use an expansionary fiscal policy, agents will incorporate this information into their expectations and change their behaviour accordingly.
Rational expectations does not seem plausible because the costs in terms of time, effort and money of acquiring all information is impossibly high. But, the weak version does not need agents to use all information, it just requires agents to make the best use of all public information, that is, to use information until the marginal benefit of using the last piece of information equals the marginal cost of acquiring that piece of information (Snowden et al 1994, pp.191-192).
Moreover, how do agents know the ‘correct’ macro model of the economy? Economists do not even know. But, the strong version of rational expectations just requires agents to not make systematically wrong errors over time, expectations are formed ‘as if’ agents know the ‘correct’ macro model of the economy. However, Lovell (1986, p.121) suggests that agents do make systematic errors when forming their expectations.
Additionally, does the average person have rational expectations? Agents could get their information from other agents with rational expectations like news reports but even the news offers conflicting reports.
Furthermore, how does rational expectations explain long recessions? Agents would surely realise quickly and adapt their expectations.
Rational expectations may also lead to multiple or even infinite equilibria meaning that “rational agents have no reason to expect any particular solution to occur, and so cannot decide upon a specific rational expectation” (Hillier 1991, p.177).
Lastly, Friedman (1979, pp.39-40) claims that agents have adaptive expectations rather than rational expectations, at least in the short-run, because rational expectations and ‘the information availability assumption’ implicitly assumes a long-run setting.
Friedman, B.M., (1979), Optimal Expectations and the Extreme Information Assumptions of “Rational Expectations” Macromodels, Journal of Monetary Economics, 5(1).
Hillier, B., (1991), The Macroeconomics Debate. Models of the closed and open economy, Oxford and Cambridge: Basil Blackwell.
Lovell, M., (1986), Tests of the Rational Expectations Hypothesis, American Economic Review, 76(1).
Muth, J., (1961), Rational Expectations and the Theory of Price Movements, Econometrica, 29(3).
Snowden, B., Vane, R. and Wynarczyk, P., (1994), A Modern Guide To Macroeconomics. An introduction to competing schools of thought, Cheltenham: Edward Elgar.
