Rational expectations theory

Rational expectations theory
See also
Diminishing marginal utility Law of supply and demand Value of money over time Hicksian substitution effect Future value Willingness to pay Indifference curve and budget line Permanent income hypothesis Consumer price index

Rational expectations theory is a theory in economics that states that people will make decisions based on the best available information and their predictions about the future. This theory is based on the idea that people are rational and will use their knowledge and understanding to make decisions that will benefit them the most. The theory states that people will use their expectations of the future to form their decisions. This means that people will make decisions based on what they think will happen in the future rather than what currently exists.

Rational expectations theory proposes that people take into account all available information when making decisions, including expectations of the future. This means that people will make decisions based on their expectations of the future, rather than just the current state of the economy. For example, if people expect inflation to increase in the future, they may decide to save more money, rather than spend it on items that may become more expensive in the future.

In addition, rational expectations theory states that people will also take into account the expected cost and benefits of their decisions. This means that people will weigh the costs and benefits of their decisions to determine if it is worth it to make the decision. For example, if people expect inflation to increase and they want to buy a house, they may decide to buy a cheaper house now that will still be worth the same amount of money in the future.

Example of Rational expectations theory application

A good example of rational expectations theory in action is the decision of whether or not to invest in stocks. If people expect stock prices to go up in the future, they may decide to invest in stocks, since they expect the value of their investment to increase. On the other hand, if people expect stock prices to go down in the future, they may decide not to invest in stocks, since they expect the value of their investment to decrease. This is an example of how people use their expectations of the future to make decisions, which is the basis of rational expectations theory.

When to use Rational expectations theory

Rational expectations theory can be used in a variety of different areas, including:

• Macroeconomic forecasting: This theory can be used to predict future macroeconomic conditions, such as inflation, GDP growth, and unemployment.
• Investment decisions: Rational expectations theory can be used to make investment decisions, such as when to buy stocks or bonds.
• Monetary policy decisions: Central banks can use this theory to make decisions about interest rates and other monetary policies.
• Business decisions: Companies can use this theory to make decisions about investments, production, and other business activities.

Types of expectations theories

• Adaptive Expectations: According to this type of rational expectations theory, people form their expectations based on the past. This means that people will use their past experiences to form their expectations of the future. For example, if inflation has been increasing steadily for the past few years, people may expect that inflation will continue to increase in the future.
• Rational Expectations: According to this type of rational expectations theory, people form their expectations based on all available information, including their knowledge and understanding of the economy. This means that people will use their understanding of the economy to form their expectations of the future.
• Efficient Markets Hypothesis: This type of rational expectations theory states that all available information is already priced in to the market, meaning that people cannot gain an advantage by using their knowledge of the economy. This means that all decisions are made based on the best available information, and people cannot gain any advantage by using their understanding of the economy.

Advantages of Rational expectations theory

• It takes into account the expected cost and benefits of decisions - Rational expectations theory takes into account the expected cost and benefits of decisions, which allows people to make decisions that are beneficial to them in the long run.
• It allows people to make decisions based on their expectations of the future - Rational expectations theory allows people to make decisions based on their expectations of the future, which can help them to make more informed decisions.
• It helps to reduce uncertainty in the economy - By allowing people to make decisions based on their expectations of the future, it helps to reduce uncertainty in the economy, since people are more likely to make decisions based on accurate information.

Limitations of Rational expectations theory

Despite its usefulness, there are certain limitations of rational expectations theory. These include:

• People may not always have perfect information: People may not always have perfect information, and thus their decisions may not always be based on the most accurate predictions.
• People may not always be rational: People may not always act in a rational manner and may make decisions based on emotional factors rather than rational considerations.
• People may have different expectations: People may have different expectations about the future, and thus their decisions may not always be based on the same information.

Other approaches related to Rational expectations theory

The rational expectations theory is related to other approaches in economics, such as adaptive expectations, which states that people will make decisions based on past experiences, and the efficient market hypothesis, which states that financial markets are efficient and prices reflect all available information.

• Adaptive expectations: This approach states that people will make decisions based on past experiences. This means that people will use their past experiences to form expectations about the future, and make decisions based on this. For example, if people experienced inflation in the past, they may expect inflation to continue in the future, and plan their decisions accordingly.
• Efficient market hypothesis: This approach states that financial markets are efficient and prices reflect all available information. This means that prices in financial markets will reflect all relevant information, such as expectations of the future and current economic conditions. This means that people will not be able to make a profit by trading on information that is not widely known.

Overall, the rational expectations theory is related to other approaches in economics, such as adaptive expectations and the efficient market hypothesis. Adaptive expectations states that people will make decisions based on past experiences, while the efficient market hypothesis states that financial markets are efficient and prices reflect all available information.

Suggested literature

• Guttman, I., Kadan, O., & Kandel, E. (2006). A rational expectations theory of kinks in financial reporting. The Accounting Review, 81(4), 811-848.
• Sargent, T. J. (2013). Rational expectations and inflation. In Rational Expectations and Inflation. Princeton University Press.