The Rational Expectations Theory is a pivotal concept and modeling technique extensively used in macroeconomics. It asserts that individuals craft their decisions based on three primary elements: human rationality, information availability, and past experiences.
The theory posits that people’s current economic expectations can actively shape the future state of the economy. This contrasts sharply with the belief that governmental policies primarily drive financial and economic decisions.
Key Takeaways
- Individuals base decisions on human rationality, accessible information, and past experiences.
- Widely used in macroeconomics, the theory helps anticipate economic influencing factors such as inflation and interest rates.
- Past outcomes significantly influence future economic expectations.
- Decisions based on existing data combined with past experiences tend to be largely correct.
Understanding Rational Expectations Theory
At the core of many business cycles and financial models, Rational Expectations Theory supports the Efficient Market Hypothesis (EMH).
Economists often rely on this doctrine to anticipate rates of inflation or other political states. If previous inflation rates exceeded expectations, this might signal to the populace that future inflation could surpass assumptions as well.
The concept of expectations in economic theories emerged as early as the 1930s when British economist John Maynard Keynes identified “waves of optimism and pessimism” as critical to business cycles.
However, it was John F. Muth’s 1961 paper, “Rational Expectations and the Theory of Price Movements,” which formally introduced the theory. The concept gained traction during the 1970s through the work of Robert E. Lucas Jr. and the neoclassical revolution in economics.
The Influence of Expectations and Outcomes
Expectations and outcomes have a reciprocal relationship, continuously influencing each other. Past outcomes shape current expectations through a feedback loop, stabilizing future event predictions over repeat situations.
Abraham Lincoln’s reflection, “You can fool some of the people all of the time and all of the people some of the time, but you cannot fool all of the people all of the time,” aligns well with Rational Expectations Theory. The theory acknowledges the possibility of forecasting errors, yet asserts these errors will not persist perpetually.
Decisions are usually correct when based on available information combined with past experiences. If an error is made, futures decisions adjust accordingly to refine expectations and behaviors.
Rational Expectations Theory: Does It Work?
Economics relies heavily on interconnected models and theories, including the principle of equilibrium. The efficacy of these theories remains debatable, notably observed during their failure to preempt or clarify the causes of the 2007-2008 financial crisis.
Given the myriad factors embedding economic models, determining their practical effectiveness isn’t straightforward. Models serve as subjective approximations to explain observable phenomena, where predictions need moderation considering the inherent randomness in data they aim to interpret.
For example, when the Federal Reserve implemented quantitative easing to counteract the 2008 financial crisis, it unintentionally set collective expectations for prolonged low-interest rates, illustrating this theory in action.
Related Terms: Efficient Market Hypothesis, Macroeconomic Policy, Inflation, Federal Reserve.
References
- The Library of Economics and Liberty. “Rational Expectations”.
- Board of Governors of the Federal Reserve System. “The Crisis and the Policy Response”.
- Federal Reserve Bank of St. Louis, FRED. “Federal Funds Effective Rate”.
