Rational expectations

economic-dictionary

Rational expectations is an economic theory that states that economic agents form their expectations rationally, using all available information.

Rational expectations assume that individuals and other economic agents estimate the value that economic variables will have in the future by efficiently using the information and experience available to them. They may even be able to anticipate the measures that the government will take to deal with a disturbance in the economy.

This means that the expectations are not biased, there may be errors but on average the expectations are correct and the errors are random. In addition, your current expectations affect the future evolution of the Economy.

Origin of rational expectations

The first ideas of rational expectations were presented by J. Muth in the early 1960s. However, they were developed with the work of other economists such as Lucas, Sargent, Wallace, and Barro.

Lucas, in particular, managed to incorporate this theory into macroeconomics and the analysis of the effects of economic policy.

Characteristics of rational expectations

Rational expectations are based on the following basic assumptions about economic agents and their behavior:

  • They are rational: They use reasoning to make assumptions. It doesn't talk about emotions, as behavioral finance argue.
  • They have relevant information such as: Information on the past evolution of the variable on which expectations are formed, information on other variables that may affect the behavior of the variable being analyzed, information on the government's economic policy in the present and in the past.
  • They act as if the rest of the agents are also rational.
  • They review their expectations and try to make adjustments so that they don't make mistakes in their estimates again.

Effects of rational expectations

One of the main effects of this theory is that it will no longer be so easy to deceive economic agents and therefore some of the economic policies that were believed to be effective are no longer effective.

Thus, for example, according to the ideas of Keynes, an expansive monetary policy would allow reducing wages (real value) without there being so much resistance from the workers. In this way, more money could be issued to increase the inflation rate, lower real wages (which would increase hiring), and lower the unemployment rate.

However, if we have agents with rational expectations, this policy would not be effective. The expected inflation rate would be close to the real one and workers would be aware that their real wages are falling.

Adherents of the theory of rational expectations proposed a revision to the Phillips curve. At the beginning, workers may not be aware that higher prices reduce their wages, so they offer work at a lower price, employers are willing to hire more and unemployment is reduced in the short term. However, in the following period, workers have already formed expectations about future inflation, they realize the wages of lower value and unemployment increases (returns to the initial value but to a higher inflation). Rational expectations make raising inflation not an effective policy to reduce unemployment.

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