Rational Expectations

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. Equivalently, this is to say that agents' expectations equal true statistical expected values. 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.

Read more about Rational ExpectationsTheory, Criticisms

Other articles related to "rational, rational expectations, expectations":

Lucas Island Model - Assumptions
... theory, agents are assumed to be rational i.e ... This assumption is more commonly known as rational expectations ... Rational expectations is the principle that agents in an economic model use the correct conditional expectations, given their information ...
Rational Expectations - Criticisms
... equilibrium (which was determined ahead of time), so that people form their expectations around this unique equilibrium ... 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 ...
Macroeconomic Policy - Development - New Keynesian Response
... economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique ... area by showing that monetary policy could be effective even in models with rational expectations when contracts locked-in wages for workers ... The rigidities of new Keynesian theory were combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models ...
Macroeconomic Policy - Development - New Classicals
... classical thought came when Robert Lucas introduced rational expectations to macroeconomics ... economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future ... Under rational expectations, agents are assumed to be more sophisticated ...
John Muth
... He is known as "the father of the rational expectations revolution in economics", primarily due to his article "Rational Expectations and the Theory of Price ... Muth asserted that expectations "are essentially the same as the predictions of the relevant economic theory." Although he formulated the rational expectations principle in the context of microeconomics ...

Famous quotes containing the words expectations and/or rational:

    Our circumstances answer to our expectations and the demand of our natures.
    Henry David Thoreau (1817–1862)

    No crime can ever be defended on rational grounds.
    Titus Livius (Livy)