Rational Expectations

Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. Equivalently, this is to say that agents' expectations equal true statistical expected values. An alternative formulation is that rational expectations are model-consistent expectations, in that the agents inside the model assume the model's predictions are valid. The rational expectations assumption is used in many contemporary macroeconomic models, game theory and other applications of rational choice theory.

Since most macroeconomic models today study decisions over many periods, the expectations of workers, consumers and firms about future economic conditions are an essential part of the model. How to model these expectations has long been controversial, and it is well known that the macroeconomic predictions of the model may differ depending on the assumptions made about expectations (see Cobweb model). To assume rational expectations is to assume that agents' expectations may be individually wrong, but are correct on average. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased and use all relevant information in forming expectations of economic variables.

This way of modeling expectations was originally proposed by John F. Muth (1961) and later became influential when it was used by Robert E. Lucas Jr and others. Modeling expectations is crucial in all models which study how a large number of individuals, firms and organizations make choices under uncertainty. For example, negotiations between workers and firms will be influenced by the expected level of inflation, and the value of a share of stock is dependent on the expected future income from that stock.

Read more about Rational Expectations:  Theory, Criticisms

Famous quotes containing the words rational and/or expectations:

    I often wish for the end of the wretched remnant of my life; and that wish is a rational one; but then the innate principle of self-preservation, wisely implanted in our natures, for obvious purposes, opposes that wish, and makes us endeavour to spin out our thread as long as we can, however decayed and rotten it may be.
    Philip Dormer Stanhope, 4th Earl Chesterfield (1694–1773)

    Let us pray that the great historic tragedy of our time may not have been enacted without instructing our whole beloved country through terror and pity; and may fulfillment verify in the end those expectations which kindle the bards of Progress and Humanity.
    Herman Melville (1819–1891)