What Is Rational Expectations Theory?

What Is Rational Expectations Theory?

You need to understand that rational expectations theory is a core concept and modeling tool in macroeconomics. It states that individuals like you base decisions on three main factors: your human rationality, the information you have access to, and your past experiences.

This theory argues that your current expectations about the economy can directly shape what the economy becomes in the future. This stands in contrast to the notion that government policies are the primary drivers of financial and economic choices.

Understanding Rational Expectations Theory

In my view, rational expectations theory serves as the primary assumption in models for business cycles and finance, forming a cornerstone of the efficient market hypothesis (EMH).

Economists rely on this doctrine to explain expected inflation rates or other economic conditions. For instance, if past inflation was higher than anticipated, you might factor that in with other data to predict that future inflation could also exceed expectations.

The use of 'expectations' in economics isn't new. Back in the 1930s, John Maynard Keynes, the renowned British economist, emphasized people's expectations about the future—calling them 'waves of optimism and pessimism'—as key to the business cycle.

But the formal theory of rational expectations came from John F. Muth in his 1961 paper 'Rational Expectations and the Theory of Price Movements,' published in Econometrica. Muth described scenarios where outcomes depend partly on what people expect. The theory gained traction in the 1970s with Robert E. Lucas Jr. and the neoclassical economics revolution.

The Influence of Expectations and Outcomes

Expectations and outcomes feed into each other. There's a constant feedback from past results to your current expectations. In repeating situations, the future tends to follow a stable pattern from the past, and you adjust your forecasts to match it.

This idea draws from Abraham Lincoln's words: '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.'

From the rational expectations perspective, Lincoln's point holds: The theory admits people make forecasting errors, but it insists those errors don't keep happening persistently.

Since you make decisions using available information and past experiences, your choices are correct most of the time. If correct, the same future expectations hold. If wrong, you adjust based on those mistakes.

Rational Expectations Theory: Does It Work?

Economics depends on interconnected models and theories. Rational expectations, for example, ties closely to the concept of equilibrium. Whether these theories work in predicting future states is always debatable, as seen in debates over models' failures during the 2007–2008 financial crisis.

Economic models involve many factors, so it's never just about working or not. They are subjective approximations of reality meant to explain observations. You must temper a model's predictions with the randomness in the data and the theories behind its equations.

When the Federal Reserve used quantitative easing in the 2008 crisis, it set expectations that were hard to meet by lowering interest rates for over seven years. As the theory predicts, people started expecting rates to stay low.