Rational Expectations
What is Rational Expectations?
Rational expectations is the assumption that people form forecasts using all available information, so their errors are random rather than systematic.
Rational expectations treats people as forecasters who use everything they know, including how the central bank and Congress usually respond to conditions. They can still be wrong, because news arrives that nobody had, but they are not wrong in the same direction over and over. The exam consequence is the policy ineffectiveness result: if a monetary expansion is announced and believed, workers and firms raise wage and price demands right away, so the price level rises and real output stays at potential. Only surprises move output. That is the sharp break from adaptive expectations, where people extrapolate from recent inflation and therefore keep underpredicting it while it rises, which is what produces a usable short-run tradeoff.
Rational Expectations: a worked example
Suppose the central bank announces that it will expand the money supply enough to raise inflation from 2 percent to 6 percent over the next year, and everyone believes it. Under rational expectations, unions negotiating a contract ask for a 6 percent wage increase immediately instead of the 2 percent they would otherwise have sought, and firms raise prices by the same amount. Real wages, real output and unemployment end up where they started, and only the price level is higher. Had the increase been a surprise, wages would have been set for 2 percent inflation, real wages would have fallen by roughly 4 percent, and firms would have hired more for a while.
The mistake students make with rational expectations
The usual reading is that rational expectations means people always predict correctly. It does not. It means forecast errors are random and average out to zero, so a household can badly miss inflation in any one year as long as it is not always too low. Perfect foresight, where the forecast is exactly right every time, is a different and stronger assumption that models use only for convenience.
Rational Expectations questions
Who developed rational expectations?
John Muth introduced rational expectations to model how firms forecast prices, and Robert Lucas, Thomas Sargent and Neil Wallace built it into macroeconomics. Lucas received the Nobel Memorial Prize in economics for developing and applying the hypothesis. The related warning that policy analysis must account for how people change behavior when the policy changes is known as the Lucas critique.
How do rational expectations affect the Phillips curve?
With rational expectations the short-run Phillips curve shifts up as soon as people expect higher inflation, so an anticipated stimulus moves the economy straight to the vertical long-run curve with no fall in unemployment. Only inflation that people did not see coming produces the usual short-run tradeoff. This is one route to the conclusion that the long-run Phillips curve sits at the natural rate of unemployment.
Is rational expectations the same as the efficient markets hypothesis?
No, rational expectations is an assumption about how people forecast, while the efficient markets hypothesis is a claim about how quickly asset prices absorb information. The two are related, since efficient markets models usually assume investors forecast rationally, but you can accept one without the other. Rational expectations is about forecasting behavior generally, not about any particular financial market.
Formula / Example
This is the live Phillips Curve sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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