Rational Expectations Theory

12 Key excerpts on "Rational Expectations Theory"

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  The 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.

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  Reformulation Of Keynesian Economics, A

  • Jagdish Handa(Author)
  • 2015(Publication Date)
  • WSPC

    (Publisher)

  6 For the intertemporal context, rational choice theory requires the consistency and transitivity of preferences and optimization to be intertemporal over the short terms up to the economic agent’s chosen horizon. Using the requirement of optimality from the rational choice literature to identify the extent of the information that is acquired means that the relevant information is that which is optimal for the agent to acquire.

  Hence, our definition of “rational” in expectations theory designates the expectations of an economic agent on the future values of variables as being rational if they: (i) use all the pertinent information available to him, (ii) the pertinent information relates to the relevant chronological periods, and (iii) the available information is that which is optimal for the economic agent to acquire (Kantor, 1979).7 We label expectations satisfying these conditions as “weak rational expectations” (weak-RE) and label the hypothesis asserting (i) to (iii) as the weak-rational expectations hypothesis (weak-REH).

  Note that rationality in the context of expectations is a property that is attributable to individual economic agents, not really to markets or to macroeconomic outcomes. Since the weak-REH allows for variations in the information available to different economic agents, it does not automatically impose an assumption requiring the identity of expectations among all market participants. To illustrate this heterogeneity of expectations, in the stock market, on any day, the optimizing decision of some economic agents will be to sell a particular stock, while the optimizing decision of some others would be to buy the stock, with such divergent behavior resulting in trades in the market that establish the market price. The actual market outcomes will then necessarily disappoint some and favor some. Hence, the heterogeneity of expectations is essential to most of the trades in some markets.

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  Beyond Mechanical Markets

  Asset Price Swings, Risk, and the Role of the State

  • Roman Frydman, Michael D. Goldberg(Authors)
  • 2011(Publication Date)
  • Princeton University Press

    (Publisher)

  Once an economist decides how to model market participants' preferences and the context within which they make decisions at all times, he no longer needs to worry about how they interpret the process driving outcomes and forecast the future. His model tells him how they think: “In rational expectations models, people's beliefs are among the outcomes of our theorizing. They are not inputs.” 10 In Rational Expectations models, the causal variables that enter a market participant's forecasting strategy are those that an economist chooses to represent her preferences and constraints. Moreover, to impose the Rational Expectations Hypothesis—to render the model's predictions on the aggregate and individual levels identical—an economist must set the weights attached to the model's causal variables to be exactly related to the parameters of the model's other components. 11 In this way, the Rational Expectations Hypothesis bars an economist from exploring explanations of forecasting that consider factors and parameters other than those appearing in his specifications of the other nonexpectational components of his model. This lack of an autonomous role for market participants' forecasting in Rational Expectations models has been viewed as their principal virtue, because it disciplines economic analysis in a way that was absent in previous models. Indeed, Lucas's stricture, “beware of theorists bearing free parameters [and causal factors arising from autonomous forecasting]” 12 had a profound impact on the evolution of economics

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  Advances 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.

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  Rational Expectations and Efficiency in Futures Markets

  • Barry Goss(Author)
  • 2005(Publication Date)
  • Routledge

    (Publisher)

  4   Rational expectations and experimental methods

  Glenn W. Harrison

  Recent developments in economic theory and experimental economics have significantly broadened the concept of ‘rational expectations’. In this chapter we review and evaluate these developments, arguing that they have important methodological implications.

  One theme of this review is that there are many senses in which it can be said that an economic agent’s expectations about the behaviour of others are ‘rational’. This is not merely a semantic issue. It will be shown that being explicit about the meaning of ‘rational behaviour’ can be crucial to an understanding of behaviour in many experiments. Moreover, it is only in an experiment, in which the ‘true model’ is known to the investigator independently of the observed behavioural outcomes, that the operational importance of the distinctions that are proposed can be fully appreciated.

  Three notions of expectations that are ‘rational’ in some useful sense are proposed. The first is what are called rationalizable expectations (RAE), following Bernheim (1984, 1986) and Pearce (1984). In this case we ask what the minimal requirements on behaviour are implied by the assumption that agents are Bayesian expected utility maximizers. This assumption is about as minimal, in terms of the degree of rationality it requires of individual behaviour, as possible.

  The second notion is called realizable expectations (REE) and is implied by the game-theoretical notion of Nash equilibrium (NE) due to Nash (1951), which requires that expectations be consistent in the sense that they are mutually realizable and stable ex post. When the expectations of all agents are realized, no agent has any desire to change his component expectation. This assumption represents a significant strengthening of the notion of RAE.

  The final notion is Muthian rational expectations (MRE), following Muth (1961). In this case it is required that the expectations of agents be consistent with the true model that is being evaluated. Whereas REE require only that behaviour conditioned on expectations be reinforced by observed outcomes, MRE further require that these observed outcomes be consistent with the model (or, at least, ‘some model’). The importance of this distinction for understanding experimental behaviour was first noted by Smith et al

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  Model Building in Economics

  Its Purposes and Limitations

  • Lawrence A. Boland(Author)
  • 2014(Publication Date)
  • Cambridge University Press

    (Publisher)

  58 Theoretical Models influenced by one’s a priori theories. In other words, expectation formation depends on theories. Facts, if they speak at all, speak only with the help of one’s theories – all facts, so to speak, are ‘theory laden’. This raises many problems unless there is some reason given for why all individuals believe in the same a priori theories [see also Frydman and Phelps, 1983]. Without a reliable inductive logic there is no reason to suspect that any two individuals would believe the same theory nor any reason for why they would react to the same information set in exactly the same way. We see now why some equilibrium model builders see that this implies random behaviour, and thus why they see a necessity of basing macroeconomics or general- equilibrium models on an understanding of stochastic processes [e.g., Hey, 1981]. In effect, the Rational Expectations Hypothesis moves the goalpost. Instead of assuming that in a general equilibrium all decision makers have acquired sufficient knowledge to make correctly maximizing decisions, particularly investment decisions, many general-equilibrium model build- ers suggest that we should not expect more of decision makers using available observational data than we would of any expert econometrician. Surely, not everyone will see such a suggestion as something realistic. Nevertheless, model builders who do invoke the assumption of rational expectations are satisfied that at least there is a consistency between what the econometric model builders would expect given the available observa- tional data and what the individual decision makers being explained would expect. Surely, it would be said, one cannot realistically expect individual decision makers to have expectations that are any more accurate than the model builder can have using the best econometric techniques. Unsystematic errors on the part of decision makers should obviously be allowed for.

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  Probability in Economics

  • Omar Hamouda, Robin Rowley(Authors)
  • 2013(Publication Date)
  • Taylor & Francis

    (Publisher)

  3 Rationality and Conditional Expectations

  Economists have used the terms 'rational' and 'rationality' for so many different concepts that it is quite tempting to attach subscripts to separate them! Besides the familiar rational choice, for example, we readily find rational degrees of belief (Keynes), rational conduct (Knight), rational processes (Hayek), and rational expectations (Muth, Lucas); even rational termination (Brams) and rational distributed lags (Jorgenson). Similarly, as conveniently summarized by March (1978) , there are bounded rationality (Simon, Lindblom, Radner), contextual rationality (March), game rationality (Brams, Harsanyi and Selton), process rationality (Edelman, Cohen and March), adaptive or experiential rationality (Day and Groves), selected rationality (Nelson and Winter), posterior rationality (Hirschman), and quasi-rationality — enough concepts to make one dizzy.

  For our purposes, it seems appropriate to concentrate on a shorter list, within which we recognize 'rationality' applied to the internal consistency of axiomatic models and to the pursuit of self-interest through optimization in the conventional mathematical treatments of rational choice; and to the wider behavioural (or procedural) approach of Simon and others, which is associated more closely with cognitive psychology, pattern recognition, rational adaptation and computational limitations. Expectations, especially conditional expectations, of stochastic variables are common for all of these forms of rationality in basic axioms determining any standard and generalized expected utility theories, in the goals for normative mathematical models, and in some approximations (involving certainty equivalents) which illustrate heuristics and clarify the realistic limits for individual optimization in a wider microeconomic context.

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  Econometrics 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 , .

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  Organizations, Individualism and Economic Theory

  • Maria Brouwer(Author)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  3  Expectations and macro economic theory The boundaries of rationality Introduction

  Human 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.

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  Rational Expectations Econometrics

  • 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

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  Encyclopedia of Governance

  • Mark Bevir(Author)
  • 2006(Publication Date)
  • SAGE Publications, Inc

    (Publisher)

  785 R ATIONAL C HOICE I NSTITUTIONALISM See N EW I NSTITUTIONALISM R ATIONAL C HOICE T HEORY Rational choice theory is a theory of human action that is committed to expectations over probabilistic outcomes and game theory. From its original articula-tion, this theory of rational decision making was put forward as a new approach to economics, warfare, and social science more generally. Rational choice theory is often simplistically con-sidered to be a theoretical generalization of either tech-nical instrumental rationality, requiring that an agent adopt the means necessary to realize a chosen end, or of economic efficiency, demanding the effective use of scarce resources as exchangeable means to achieve ends. Instead, rational choice theory represents a unique approach to social science that locates human rationality in an agent’s mutually consistent hierarchy of preferences over all conceivable global nonex-changeable end states. Additionally, rational agents are presumed to make decisions (a) in strategic environ-ments in which one agent chooses actions in direct response to the actions that others are calculated to take and (b) in situations with either unknowable (uncertain) or well-defined (risky) probabilities of what outcomes may result as a consequence of actions. Elements and Structure of Rational Choice Theory: Expectations and Game Theory In rational choice theory, agents are described by their unchanging sets of preferences over all conceivable global outcomes, such as whether candidate Smith, Davidson, or Nelson will win an election, whether dinner will consist of chicken, fish, or tofu, or whether a public policy is one of waging war, negotiating a set-tlement, or relying on the international community of nation states to provide leadership.

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  Rethinking Rational Choice Theory

  A Companion on Rational and Moral Action

  • Jan de Jonge(Author)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  In Part I, I present an overview of the development of rational choice theory. It tells how the human agent transformed from a rational utility 3 4 Rethinking Rational Choice Theory maximizer into an irresolute individual whose present aims dominate his prudential objectives. The theory that receives most attention in Part I is expected utility theory. It is widely used and strongly criticized. This criticism was the reason that an alternative theory based on the Prospect theory of the psychologists Kahneman and Tversky was developed and called behavioural econom- ics. Behavioural economics got a new impulse when brain imaging was made possible by means of the fMRI technology. For many behavioural economists it promised to open the black box where decision-making takes place. I discuss individual decision-making under conditions of uncertainty in three chapters, each time from a different perspective. In Chapter II the perspective is expected utility theory, in Chapter III the perspective is behavioural choice theory and in Chapter IV the perspective is neuroeconomics. Chapter I outlines the theory of individual decision-making with full information. Consumer theory was the first manifestation of this individual decision theory. The major themes in Chapter I are the trans- formation of the utility function and the question of whether agents in rational choice theory are pictured as persons who are motivated only by self-interest. The next three chapters tell the story of the emergence of behavioural economics and neuroeconomics and how the rise of these new approaches to individual decision-making was accompanied by the introduction of ‘dual reasoning systems’. In the first dual system, expected utility theory appeared as the normative theory and prospect theory (or behavioural theory) as the descriptive theory. This dual system was followed by the distinction that Kahneman introduced as system 1 and system 2.

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