Rational Expectations

The rational expectations theory is a macroeconomics concept widely used modeling technique. This theory states that most common people’s decisions are based on three key factors: past experiences, the information available to them, and their human rationality. Further, this theory shall advise that individuals’ current economic expectations affect what the economy’s future state shall become.

Rational expectations theory assumes that people act rationally and based upon three factors: experience, current mindset, and the information available to them, that decide the economy's future. These are the future best guesses. This system ensures internal clarity in factors or systems with uncertainty. Moreover, the theory also places the impetus on outcomes not being too different in a systematic manner.

• The rational expectations theory is a widely-used macroeconomic modeling technique stating that past experiences, available information, and rationality influence most people's decisions.
• Economic policies have implications on people's expectations, which can affect their behavior and subsequent outcomes.
• The effects of expansionary fiscal policies may differ depending on how individuals change their behavior in response to policy expectations.
• The rational expectations theory can help policymakers make better-informed decisions by considering how people's expectations may influence the outcome of economic policies.

Rational expectations states that individuals make decisions based on their understanding of human psychology, available data, and their experiences in the past. However, it is also made clear that individuals can be wrong about these outcomes. That is, these outcomes can be different than their expectations.

The rational expectations theory has some explanations and versions, which can be strong or weak.

• The "strong" version theory and explanation assume that individuals can access all the available information and shall make rational decisions, and those will be based on that information.
• The "weak" version theory assumes that individuals lack time to process all the relevant information, but they finalize or make decisions based on their knowledge, which would be limited.

Let us understand the rational expectations hypothesis in depth through the discussion below.

1. The Theory of Cobweb is Not Valid Always i.e.; Prices Become More Volatile: For example, high supply leads to lower costs, and when supply is cut off, prices increase. And again, supply increases and this circle shall continue.
2. Efficient Market Hypothesis: The stock market assumes that it captures all the relevant information while pricing it, including material nonpublic information.
3. Permanent Income Hypothesis: Individuals judge whether the drop in their income level is permanent or temporary. They also consider future income and make consumption decisions based on that.

The implications of the rational expectations hypothesis can be different depending upon what people assume. However, let us understand common threads amidst these assumptions through the explanation below.

The implications of rational expectations can be different depending upon what people assume. For example, after the 2008 financial crisis, the Federal Reserve decided to use the quantitative easing program to revive the economy. Due to this, there was a reduction rate of interest for more than seven years, and the implication per theory is that individuals, began to perceive that interest rates shall remain low.

Like any other theory or hypothesis, the rational expectations theory is subject to its share of criticisms. Let us understand them to fully understand this concept.

1. Present value bias states that the individual's current value on short-term income is more than income in a longer period.
2. Most individuals are unaware of the impact of policies on the economy. For example, inflation impacts the economy.
3. Most individuals do not learn from their past mistakes, i.e., if certain stocks performed well in the past, people keep buying them even though fundamentally it is no longer viable to purchase.
4. A couple of economics theories suggest that people mostly act irrationally.
5. Asset bubbles, for example, a recent hike in bitcoin values. Then, after a long ride, it started falling.

The rational expectations theory suggests that individuals act incorrectly at certain times. Then, on average, these individuals can be correct to learn from previous errors.

The economic policy also has implications due to the rational expectations theory. For example, the impact of fiscal policy, which is expansionary, shall not be the same if individuals change their behavior due to their expectations on the policy that is certain to have an outcome.

For a theory with such elaborate measures and methodologies, it is obvious to have challenges and hurdles to calculating it. Let us learn about them through the points below.

• It incorporates a lot of factors in decision-making.
• After considering all the relevant information, all people and individuals need to be rational and act upon it.
• People need to behave per the expectations of the policies placed by the government.

In a world where each individual has their set of expectations from situations, people, and other uncontrollable, it is inevitable that they might follow a certain checklist to ascertain them. These two types of expectations are often discussed together. However, their differences lie in their basics. Let us understand them through the discussion below.

The individuals using adaptive decision-makers use previous events and trends to predict future outcomes. At the same time, rational decision-making individuals shall use the best information available in the market to make the best decisions. It is also called backward-based thinking decision making.

In adaptive theory, people adapt to previous and past events. In rational expectations theory, people will not make decisions until they have gathered all relevant information.

This article is a guide to what are Rational Expectations. Here we compare it with adaptive expectations, explain its examples, criticisms, and challenges. You can learn more about it from the following articles: -

• Expectations Theory
• Inflation Expectations
• Segmented Market Theory
• Stock Market Bubble