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):