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Rational Expectations Theory Definition and How It Works

What is rational expectations theory.

The rational expectations theory is a concept and modeling technique that is used widely in macroeconomics . The theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences.

The theory suggests that people’s current expectations of the economy are, themselves, able to influence what the future state of the economy will become. This precept contrasts with the idea that government policy influences financial and economic decisions.

Key Takeaways

• The rational expectations theory posits that individuals base their decisions on human rationality, information available to them, and their past experiences.
• The rational expectations theory is a concept and theory used in macroeconomics.
• Economists use the rational expectations theory to explain anticipated economic factors, such as inflation rates and interest rates.
• The idea behind the rational expectations theory is that past outcomes influence future outcomes.
• The theory also believes that because people make decisions based on the available information at hand combined with their past experiences, most of the time their decisions will be correct.

Understanding Rational Expectations Theory

The rational expectations theory is the dominant assumption model used in business cycles and finance as a cornerstone of the efficient market hypothesis (EMH) . 

Economists often use the doctrine of rational expectations to explain anticipated inflation rates or any other economic state. For example, if past inflation rates were higher than expected, then people might consider this, along with other indicators, to mean that future inflation also might exceed expectations.

Using the idea of “expectations” in economic theory is not new. In the 1930s, the famous British economist, John Maynard Keynes assigned people’s expectations about the future—which he called “waves of optimism and pessimism”—a central role in determining the business cycle.

However, the actual theory of rational expectations was proposed by John F. Muth in his seminal paper, “Rational Expectations and the Theory of Price Movements,” published in 1961 in the journal, Econometrica . Muth used the term to describe numerous scenarios in which an outcome depends partly on what people expect will happen. The theory did not catch on until the 1970s with Robert E. Lucas, Jr . and the neoclassical revolution in economics.

The Influence of Expectations and Outcomes

Expectations and outcomes influence each other . There is continual feedback flow from past outcomes to current expectations. In recurrent situations, the way the future unfolds from the past tends to be stable, and people adjust their forecasts to conform to this stable pattern.

This doctrine is motivated by the thinking that led Abraham Lincoln to assert, “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 perspective of rational expectations theory, Lincoln’s statement is on target: The theory does not deny that people often make forecasting errors , but it does suggest that errors will not recur persistently.

Because people make decisions based on the available information at hand combined with their past experiences, most of the time their decisions will be correct. If their decisions are correct, then the same expectations for the future will occur. If their decision was incorrect, then they will adjust their behavior based on past mistakes.

Rational Expectations Theory: Does It Work?

Economics relies heavily on models and theories, many of which are interrelated. For example, rational expectations have a critical relationship with another fundamental idea in economics: the concept of equilibrium . The validity of economic theories—do they work as they should in predicting future states?—is always arguable. An example of this is the ongoing debate about existing models’ failure to predict or untangle the causes of the 2007–2008 financial crisis.

Because myriad factors are involved in economic models, it is never a simple question of working or not working. Models are subjective approximations of reality that are designed to explain observed phenomena. A model’s predictions must be tempered by the randomness of the underlying data it seeks to explain, and the theories that drive its equations. 

When the Federal Reserve decided to use a quantitative easing program to help the economy through the 2008 financial crisis, it unwittingly set unattainable expectations for the country. The program reduced interest rates for more than seven years. Thus, true to theory, people began to believe that interest rates would remain low.

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 ."

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Rational Expectations and Inflation (3rd edn)

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This collection of essays uses the lens of rational expectations theory to examine how governments anticipate and plan for inflation, and provides insight into the pioneering research for which the author was awarded the 2011 Nobel Prize in economics. Rational expectations theory is based on the simple premise that people will use all the information available to them in making economic decisions, yet applying the theory to macroeconomics and econometrics is technically demanding. This book engages with practical problems in economics in a less formal, noneconometric way, demonstrating how rational expectations can satisfactorily interpret a range of historical and contemporary events. It focuses on periods of actual or threatened depreciation in the value of a nation's currency. Drawing on historical attempts to counter inflation, from the French Revolution and the aftermath of World War I to the economic policies of Margaret Thatcher and Ronald Reagan, the book finds that there is no purely monetary cure for inflation; rather, monetary and fiscal policies must be coordinated. This fully expanded edition includes the author's 2011 Nobel lecture, “United States Then, Europe Now.” It also features new articles on the macroeconomics of the French Revolution and government budget deficits.

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Rational Expectations and Inflation

Third edition.

• Thomas J. Sargent
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• Language: English
• Publisher: Princeton University Press
• Copyright year: 2013
• Edition: Third
• Audience: Professional and scholarly;College/higher education;
• Main content: 392
• Keywords: rational expectations theory ; inflation ; economic decision ; macroeconomics ; econometrics ; French Revolution ; budget deficit ; rational expectations ; econometric model ; behavior ; government policy ; agent ; investment decision ; government deficit ; government finance ; monetary policy ; fiscal policy ; economy ; dynamic game ; Reaganomics ; momentum ; Austria ; Hungary ; Germany ; Poland ; hyperinflation ; Czechoslovakia ; Margaret Thatcher ; Raymond Poincar ; Poincar miracle ; Ronald Reagan ; coordination ; monetary authority ; fiscal authority ; monetarism ; Cagan-Bresciani-Turroni effect ; intertemporal government budget ; government budget ; tax smoothing ; real interest rates ; government debt ; depreciation ; Hong Kong dollar ; Hong Kong ; real estate ; common stock ; float policy ; exchange rate ; Brazil ; United States ; taxes ; government expenditures ; macroeconomic theories ; government budget constraint ; Britain ; France ; unpleasant arithmetic ; sustainable plan ; currency ; European Union
• Published: May 5, 2013
• ISBN: 9781400847648

Rationality, History of the Concept

• Living reference work entry
• First Online: 01 January 2016
• Cite this living reference work entry

• Esther-Mirjam Sent 2  

2 Citations

This article offers a historical and methodological perspective on the concept of rationality. It gives an overview of the various interpretations of the notion, from self-interest to rational choice and expected utility to strategic rationality and rational expectations. It pays special attention to the ethical dimensions of the concept. The article further places rationality within a long-ranging discussion concerning the status of assumptions within economics. It explicitly considers efforts to test rationality directly. The article concludes with an evaluation of recent efforts to replace rationality with the notion of bounded rationality.

This chapter was originally published in The New Palgrave Dictionary of Economics , 2nd edition, 2008. Edited by Steven N. Durlauf and Lawrence E. Blume

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Sent, EM. (2008). Rationality, History of the Concept. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-349-95121-5_2834-1

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Received : 12 September 2016

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Assessing Rational Expectations

Sunspot Multiplicity and Economic Fluctuations

by Roger Guesnerie

ISBN: 9780262072076

Pub date: April 13, 2001

• Publisher: The MIT Press

343 pp. , 6 x 9 in ,

• 9780262072076
• Published: April 2001

Out of print

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• Description

Roger Guesnerie contributes to the critical assessment of the Rational Expectations hypothesis (REH).

In this book Roger Guesnerie contributes to the critical assessment of the Rational Expectations hypothesis (REH). He focuses on the multiplicity question that arises in (infinite horizon) Rational Expectation models and considers the implications for a theory of endogenous fluctuations. The REH, which dominates the economic modeling of expectations in most fields of formalized economic theory, is often associated with an optimistic view of the working of the markets—a view that Guesnerie scrutinizes closely. The book is divided into four parts. The first part uses the framework of simple models to characterize the stochastic processes that trigger self-fulfilling prophecies and examines the connections between periodic equilibria (cycles) and stochastic equilibria (sunspots). (A sunspot is a random shock uncorrelated with underlying economic fundamentals.) The second part views sunspot equilibria as overreactions triggered by small variations of intrinsic variables—rather than as fluctuations with no trigger—and looks at the consequences for a monetary theory à la Lucas. The third part develops the basic theory to encompass more complex, multidimensional systems. It focuses in particular on the special class of equilibria generating small fluctuations around a steady state. Broadening the scope, the fourth part looks at the stability of cycles, sunspots in systems with memory, and current research on rational expectations.

Roger Guesnerie is Professor at the Collège de France and President of the Paris School of Economics. He is the author of Assessing Rational Expectations and Assessing Rational Expectations 2 (MIT Press, 2001, 2005).

This book is a master work by one of the three founders of the modern field of General Equilibrium Theory. All economists will want to own this volume. It covers not only classical theory but also the research frontier. It is written with the beauty and clarity that one would expect of a founding father. William A. Brock, Vilas Research Professor of Economics, The University of Wisconsin, Madison

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Rational Expectations and Inflation - Thomas J. Sargent (Third Edition)

Rational expectations theory is based on the simple premise that people will use all the information available to them in making economic decisions, yet applying the theory to macroeconomics and econometrics is technically demanding.

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Alain Paquet

Ecos de Economía - A Latin American Journal of Applied Economics

The Rational Expectations Hypothesis was first developed as a theoretical technique aimed at explaining agents’ behavior in a given environment. In particular, it describes how the outcome of a given economic phenomenon depends to a certain degree on what agents expect to happen. Subsequently, it was introduced into macroeconomic models as a way to explain the ineffectiveness of monetary policy. Since then, most of these models have been based on the rational expectations assumption. This paper assesses the real life application of this feature based on two arguments: the determination of an objective reality through beliefs and subjective expectations; and the exclusion of the evolution of human knowledge and innovation in macroeconomic models.

Miguel Virasoro

In economic models, expectations about future parameters influence the behaviour of the agents. To have a well-defined model one has to write down a closed system of equations that relates expected and real values. Infinite rationality with perfect foresight provides a simple and appealing recipe. Other possibilities include adaptive expectations and/or evolving, adaptive agents. In this paper we examine critically some of these ideas in a simple model for inflation.

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Macroeconomic Dynamics

Warren Young

The transcript of a panel discussion marking the 50th anniversary of John Muth's “Rational Expectations and the Theory of Price Movements” (Econometrica 1961). The panel consisted of Michael Lovell, Robert Lucas, Dale Mortensen, Robert Shiller, and Neil Wallace. The discussion was moderated by Kevin Hoover and Warren Young. The panel touched on a wide variety of issues related to the rational-expectations hypothesis, including its history, starting with Muth's work at Carnegie Tech; its methodological role; applications to policy; its relationship to behavioral economics; its role in the recent financial crisis; and its likely future.The panel discussion was held in a session sponsored by the History of Economics Society at the Allied Social Sciences Association (ASSA) meetings in the Capitol 1 Room of the Hyatt Regency Hotel in Denver, Colorado.

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Classical Theory of Interest: Assumptions, Demand, Features and Criticisms | Economics

In this article we will discuss about:- 1. Assumptions of Classical Theory of Interest 2. Supply and Demand for Capital 3. Determination of Rate of Interest 4. Features of Classical Theory 5. Criticisms.

The economists like Ricardo, J. S. Mill, Marshall and Pigou developed the, classical theory of interest which is also known as the capital theory of interest or the saving-investment theory of interest or the real theory of interest. According to this theory, interest is a real phenomenon and the rate of interest is determined exclusively by the real factors, i.e., the supply of and demand for capital under perfect competition. The supply of capital is governed by thrift (i.e. saving) or time preference and the demand for capital is influenced by the productivity of capital.

Assumptions   of Classical Theory of Interest :

The classical theory of interest is based upon the following assumptions:

(i) Perfect competition exists in the factor market.

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This assumption has the following implications:

(a) The equilibrium rate of interest is determined by the competitive forces of demand and supply in the capital market.

(b) Interest rate is flexible, i.e., it freely moves to whatever level the demand and supply forces dictate.

(ii) The theory assumes full employment of resources.

(a) Saving involves sacrifice of abstaining from or postponing of consumption and interest is the reward for abstinence or waiting: it is only when all resources are fully employed, higher rate of interest is paid to induce people to save or abstain from consumption or postpone consumption

(b) Income level is assumed to be constant; it is at the full employment level that income and output do not change and become constant.

(c) The assumptions of full employment and given level of income lead to the further assumption that the demand and supply schedules of capital are independent and do not influence each other; it is only when income changes as a result of a change in investment, that saving changes in consequence.

(iii) Economic agents act rationally, i.e., they are motivated by self-interest and want to maximise economic benefit.

(iv) The price level is assumed to be constant. If it changes then the economic agents do not suffer money illusion, i.e., savers and investors react to changes in the real interest rates and not the changes in the money interest rates.

(v) Money is neutral and serves only as a medium of exchange and not as a store of value.

Supply and Demand for Capital :

Supply of Capital:

The supply of capital depends upon savings which, in turn, depend upon a number of psychological, economic and institutional factors broadly classified as – (a) the will to save, (b) the power to save, and (c) the facilities to save. Saving means curtailment of consumption or postponement of the present consumption. Thus, saving involves a sacrifice, abstinence or waiting. The rate of interest is considered to be the reward for abstinence or waiting.

It is an inducement for the act of saving or foregoing the present consumption. In deciding between the present consumption (which involves no saving) and the future consumption (which requires saving), the individual has to take into consideration the opportunity cost of each alternative and the opportunity cost is measured by the rate of interest.

For example, if the current rate of interest is 5% then by consuming Re. 1 of income now, the individual is foregoing the consumption of Rs. 1.05 one year later. Thus, the higher the current rate of interest, the greater the opportunity cost of present consumption as compared to the future consumption, and, as a result, greater the inducement to save out of the present income.

Hence, saving is interest elastic and there is a positive relationship between the rate of interest and saving. The supply curve of capital or the saving schedule (SS curve in Figure 1) slopes upward to the right which indicates that higher the rate of interest, larger will be the savings and greater will be the supply of capital and vice versa.