Economics
Rational Expectations
Rational expectations is an economic theory that suggests individuals make predictions about the future based on all available information, including past events and current market conditions. This theory assumes that people are forward-looking and make decisions based on rational analysis, leading to more accurate predictions and efficient market outcomes.
Written by Perlego with AI-assistance
Related key terms
1 of 5
10 Key excerpts on "Rational Expectations"
eBook - PDFThe Influence of Uncertainty in a Changing Financial Environment
An Inquiry into the Root Causes of the Great Recession of 2007-2008
- Ricardo A. Halperin(Author)
- 2017(Publication Date)
- Palgrave Macmillan(Publisher)
The fact that so many smaller firms fail soon after they are established 6 does suggest that the analysis leading to the decision to set them up was not as thorough as theory would lead us to expect. Rationality in the development of expectations seems like a logical cor- ollary to the assumption of rational behavior. It implies that consumers develop their expectations about the future by drawing on all the available information from the past, learning by doing how to translate this infor- mation into their expectations which, on average, tend to be validated by results. The concept of Rational Expectations asserts that outcomes do not differ system- atically (i.e., regularly or predictably) from what people expected them to be. 7 What holds for consumers presumably would hold even more strongly for business firms, which have more resources to examine past records in order to develop their expectations for the future, and take their decisions accordingly. This is not to argue that everyone makes rational decisions every time, or holds Rational Expectations about everything, as the periodic failures R.A. HALPERIN 171 of those forecasting the end of the world by specific dates have repeat- edly shown. It is enough to argue that rationality is the dominant force in economic decision making and in formulating expectations, so that the discrepancy between expected and actual outcomes becomes an unpre- dictable variable, which will err as much on the optimist as on the pessi- mist side. Rational Expectations theory builds upon these simple concepts and examines their implications in real life.
Available until 27 Jan |Learn more- Prabhat Patnaik(Author)
- 2009(Publication Date)
- Columbia University Press(Publisher)
But there are in addition serious logical problems with the concept, in particular when applied to the state of the economy as a whole. Some Implications of Rational Expectations In the previous chapter we drew a distinction between expectations underlying the equilibrium and expectations about the equilibrium, a distinction corresponding to what one might call expectations about what is going to happen in the coming period or periods and expectations about the nature of the equilibrium in the current period 58 the infirmit y of monetarism itself. The first question that arises is: To what do Rational Expectations refer? The answer is: Both. One may be tempted to believe that the domain of Rational Expectations can be broken up, that a situation can be imagined where every economic agent correctly predicts the equilibrium of the current period on the basis of knowledge of every economic agent’s expectations about the next period, even though these expecta-tions themselves are divergent and therefore not rational. Such a belief, however, is erroneous. In order to know every economic agent’s expectations about the future in the absence of clairvoyance, one must know his or her expectation-formation rule. For correctly predicting the equilibrium of the current period, therefore, every eco-nomic agent, apart from knowing many other things, must know the expectation-formation rule of every economic agent. But this is knowledge that no amount of “learning” can help one to acquire. It is logically impossible to infer in the case of any agent the expectation-formation rule from his or her observed behavior over a sequence of periods, no matter how long, because, first, one cannot infer from observed behavior a unique set of expectations, and second, one cannot infer from a known set of expectations a unique expectation-formation rule.
- R. Koppl(Author)
- 2002(Publication Date)
- Palgrave Macmillan(Publisher)
With Rational Expectations, everyone knows the future. There is widespread dissatisfaction with the Rational Expectations hypothesis. Fundamental criticisms of it are widely accepted. But no clear replacement has yet come along. Fundamental work on learning and expectations has been done by a variety of very different authors. (A few of the more prominent examples are Arthur 3 1994a, 1994b, Bikhchandani et al. 1992, Binmore 1987, Choi 1993, Denzau and North 1994, and O’Driscoll and Rizzo 1996.) This work has not yet given us a complete theory with empirical implications. Hayek identified a gap in our knowledge. In this book I propose a theory of expectations that helps to fill this gap. The theory explains the process by which individual knowledge is changed. My general theory leads to the theory of Big Players. The theory of Big Players identifies some of the conditions under which the tendency toward equilibrium exists. It has testable implications. My co-authors and I have conducted several tests. So far, the theory holds up. Like other efforts, my theory is incomplete. But it provides broad foundations for further work in the area, and I have drawn from it a reasonably broad set of empirical implications. The meaning of “expectations” The term “expectations” covers two different economic concepts. A theory of expectations should encompass both senses of the term. It is unfortunate that one word covers both concepts. But past usage dictates that both concepts identify “expectations.” In its first meaning, expectations are expectations. In its second meaning, expectations are “as-if” rationalizations. Consider an American crossing the street in London. He knows perfectly well that Londoners drive on the left and that he must look to the right when he steps into the street. But when he does step into the street, he looks to the left. In one sense, he expects cars to drive on the left. If you ask him, he will tell you Londoners drive on the left.
eBook - PDFAdvances in Macroeconomic Theory
International Economic Association
- J. Drèze(Author)
- 2001(Publication Date)
- Palgrave Macmillan(Publisher)
Part II Money and Finance 5 How the Rational Expectations Revolution has Changed Macroeconomic Policy Research* John Taylor Stanford University, USA The Rational Expectations hypothesis is by far the most common expecta- tions assumption used in macroeconomic research today. This hypothesis, which simply states that people’s expectations are the same as the forecasts of the model being used to describe those people, was first put forth and used in models of competitive product markets by John Muth in the 1960s. But it was not until the early 1970s that Robert Lucas (1972, 1976) incorporated the Rational Expectations assumption into macro- economics and showed how to make it operational mathematically. The ‘Rational Expectations revolution’ is now as old as the Keynesian revolu- tion was when Robert Lucas first brought Rational Expectations to macro- economics. This Rational Expectations revolution has led to many different schools of macroeconomic research. The new classical economics school, the real business cycle school, the new Keynesian economics school, the new polit- ical macroeconomics school, and more recently the new neoclassical syn- thesis (Goodfriend and King (1997)) can all be traced to the introduction of Rational Expectations into macroeconomics in the early 1970s (see the dis- cussion by Snowden and Vane (1999), pp. 30–50). In this chapter I address a question that I am frequently asked by stu- dents and by ‘non-macroeconomist’ colleagues, and that I suspect may be on many people’s minds.
eBook - ePub- Charles McCann(Author)
- 2003(Publication Date)
- Taylor & Francis(Publisher)
Forecasts (expectations) are ‘rational’ as rationality is defined, viz., as utilizing efficiently all available information affecting the time path of the variables of interest (e.g., prices, interest rates, etc.). Such a postulate simply ensures that errors are consistent among the participants in the market process; it serves to generate a stationary, homogeneous set of signals, but in no way postulates a theory of behavior in the face of uncertainty. 238 This attempt by Muth to force rationality by requiring that economic actors behave in a manner consistent with the underlying model of the economy is then similar in form to Savage’s (and Raiffa’s) expressed desire that decision-makers re-evaluate their decisions on the basis of a consistent set of axioms and thereby act accordingly. In so doing, actors must be rational since they must act in accordance with a set of rational decision axioms. But Muth requires much stronger assumptions than those considered by Savage. Muth’s probabilities are imposed objectively, not derived in any subjective manner. Muthian Rational Expectations is programmed decision-making. The focus in Rational Expectations on model building and a form of Friedmanian pragmatism necessitated a redefinition of equilibrium, away from the classical economic conception (as perceived somewhat erroneously by neoclassical writers in their quest for precursors) derived from classical mechanics of a system either at rest or approaching in the limit a given, fixed value or path and hence not receptive to internal change which would allow deviations from such a path (the ‘stationary state’ in Marshall’s terms). The new definition of equilibrium proposed by Lucas, for example, whose work resurrected the intuitions of Muth, emphasizes the clarification and explication of objectives and environmental parameters, consistency, and feasibility (Lucas, 1987, p. 16)
eBook - PDFEconometrics and the Philosophy of Economics
Theory-Data Confrontations in Economics
- Bernt P. Stigum(Author)
- 2015(Publication Date)
- Princeton University Press(Publisher)
Muth’s idea of expectations formation constitutes the essential ingredient of the rational ex-pectations hypothesis (REH) in economics. Largely due to the seminal works of Robert E. Lucas (Lucas, 1972a,b, 1975), the REH surfaced in macroeconomic studies of inflation and the natural rate of unemployment in the 1970s. In these studies economists hypothesized that it served the best interests of utility-maximizing consumers and profit-maximizing firms to predict the rate of inflation as accurately as possible. To do that successfully the individuals in question needed to take all available information into account, including forecasts of changes in monetary and fis-cal policies. With such information they might make inaccurate assessments of probable changes in the price level, and different individuals were likely to make different forecasts. Still, so economists hypothesized, on the average the predictions would be right. Moreover, the mistakes that the given individuals as a group made in forecasting the rate of inflation would be random and un-correlated with the information they possessed. These ideas find expressions in the macroeconomic model I describe in E 7.9, which I have got from Hashem Pesaran, who ascribes it to Lucas (cf. Pesaran, 1987, pp. 26–29). E 7.9 Suppose that the behavior over time of an economy can be described by the following system of equations: y d t + p t = m t + v, t = 1 , 2 , . . . (1) 162 CHAPTER 7 y s t − ¨ y t = α ( p t − p ∗ t ) + ε t , t = 1 , 2 , . . . (2) y s t = y d t , t = 1 , 2 , . . . (3) Here y d , y s , and ¨ y are the logarithms, respectively, of the demand (for), supply, and natural level of aggregate output; p and p ∗ are the logarithms, respectively, of the actual price level and the price level that the members of the economy in one period expected to prevail in the next period; m and v are the logarithms, respectively, of the money supply and the velocity of money; t records relevant periods, and { ε t , t = 1 , 2 , .
eBook - ePub- Maria Brouwer(Author)
- 2012(Publication Date)
- Routledge(Publisher)
3 Expectations and macro economic theory The boundaries of rationality IntroductionHuman action can be directed towards obtaining immediate results, like eating to still hunger. It can also look further ahead and be directed towards future results. Investment spending falls in the latter category. The link between action and result becomes more uncertain if people embark on new ventures whose results will only appear after considerable time. The results of human action are predictable if people follow time honored routines. The results of investment spending in dynamic market economies, however, are uncertain. All investors expect to benefit from investment, but not all expectations are fulfilled. Thwarted expectations lie at the heart of investment busts and booms in market economies. Macro economic theory has attempted to model expectations and their impact on investment decisions. Macro economic theory wants to explain the movements of the economy at large. It looks at aggregate categories like consumption, investment and government spending. Investment spending is a central category, since it relates the present to the future. Investments spring from savings. Firms in market economies can either invest their retained earnings or obtain external finance on capital markets to carry out their plans. New firms have no recourse to retained earnings and are, therefore, more dependent on external finance. Market economies that fund new firms increase diversity and mobility. Successful firms attract people and funds, while failing firms lose labor and capital. Performance of firms is measured against that of rivals. Success and failure are relative concepts in market economies.But a picture of firms pursuing different plans with different outcomes does not emerge from standard economic theory. Firms are assumed to react identically to exogenous demand and supply shocks and do not have plans of their own. Workers are depicted as members of homogenous groups whose membership determines their remuneration. Employees have little choice, if all firms are identical and pay identical wages. Investors do not need to make individual valuations if they follow the recommendations of rating agencies and other experts. Economic theory, therefore, does not depict firms as propelled by human imagination, but portrays them as identical cogs in the economic machine that are swept around by anonymous market forces and not by individual plans and opinions.
- Truman F. Bewley, Truman F. BEWLEY(Authors)
- 2009(Publication Date)
- Harvard University Press(Publisher)
8 Rational Expectations Equilibrium and the Permanent Income Hypothesis We have seen that in an ideal world, Arrow-Debreu and Arrow markets for contingent claims make it possible for consumers to move purchas-ing power across time and events and provide advance knowledge of future prices that can be used for planning investment, production, and consump-tion. Although actual economies do not have a complete set of Arrow-Debreu markets, their functions are performed to some extent by insur-ance, borrowing and lending, forward commodity markets, and long-term contracts. The need for markets for contingent claims is further diminished by accumulation of assets for self-insurance and by the use of past experi-ence to predict future prices. I define a notion of Rational Expectations equi-librium that represents a world in which self-insurance and predictability of future prices are carried to extremes. There are no markets for contingent claims, and goods and services are exchanged only on current markets for current unit of account. The marginal utility of wealth of each consumer remains constant, and people know what prices will be in future dated events and know the probabilities of those events. I apply the term perma-nent income hypothesis to the assumption that the marginal utility of wealth or money is constant. This hypothesis is an idealized version of the more pragmatic permanent income hypothesis introduced by Milton Friedman (1957). Rational Expectations refers to knowledge of the probabilities of events and of future prices as functions of dated events. The meanings of the terms permanent income hypothesis and Rational Expectations, as used here, are close to those used in the literature on macroeconomics. Both as-sumptions may be reasonable approximations of reality when applied to short intervals of time during which no major changes occur.
eBook - PDF- Lars Peter Hansen, Thomas Sargent(Authors)
- 2019(Publication Date)
- CRC Press(Publisher)
3 Exact Linear Rational Expectations Models: Specification and Estimation by Lars Peter HANSEN and Thomas J. SARGENT Introduction A distinguishing characteristic of econometric models that incorpo-rate Rational Expectations is the presence of restrictions across the pa-rameters of different equations. These restrictions emerge because peo-ple's decisions are supposed to depend on the stochastic environment which they confront. Consequently, equations describing variables af-fected by people's decisions inherit parameters from the equations that describe the environment. As it turns out, even for models that are lin-ear in the variables, these cross-equation restrictions on the parameters can be complicated and often highly nonlinear. This paper proposes a method for conveniently characterizing cross-equation restrictions in a class of linear Rational Expectations models, and also indicates how to estimate statistical representations satisfying these restrictions. For most of the paper, we restrict ourselves to models in which there is an exact linear relation a.cross forecasts of future values of one set of variables and current and past values of some other set of variables. The key requirement is that all of the variables entering this relation must be observed by the econometrician. While probably only a minority of Rational Expectations models belong to this class, it does contain interesting models that have been advanced to study the term structure of interest rates, stock prices, consumption and permanent income, the dynamic demand for factors of production, and many other subjects. It is useful to compare the class of exact models with the class stud-ied by Hansen and Sargent (1980a). The differences lie entirely in the interpretations of the error terms in the equations that are permitted. In Hansen and Sargent (1980a), random processes which the econome-trician treats as disturbances in decision rules can have a variety of 45
eBook - PDF- Stanley Fischer(Author)
- 2008(Publication Date)
- University of Chicago Press(Publisher)
In the same way, the specification and estimation of inventory investment, which is not explained at this stage, would require the use of unobservable variables such as sales expecta- tions and, thus, an assumption about the formation of these expecta- tions in the sample period. Specification of such relations does not present particular problems and if Rational Expectations are assumed, the implied cross-equation constraints should help rather than hinder estimation (Wallis 1977 or Sargent 1978). Even a detailed and reliable model of aggregate demand is of little use without a model of aggregate supply. Although the model of supply used here has both theoretically and empirically desirable properties, it is neither derived from theory nor estimated. The question of whether we can specify and estimate a policy invariant model of aggregate supply is therefore not answered by this paper. 2. Once a model is specified and estimated, the technical problems involved in obtaining policy simulations under the assumption of ra- tional expectations are easily solved. A policy simulation requires the specification for all simulation periods of all current expectations for all future values of all exogenous variables. Although this implies more cumbersome simulations than those in existing models which only re- quire current values of the exogenous variables, this is a logical conse- quence of the assumption of Rational Expectations. The policies considered here are both simple and deterministic but there are no conceptual or technical problems in considering feedback or stochastic rules or both. 101 The Monetary Mechanism in the Light of Rational Expectations 3.
Index pages curate the most relevant extracts from our library of academic textbooks. They’ve been created using an in-house natural language model (NLM), each adding context and meaning to key research topics.
