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 have always been a friend to hero-worship; it is the only rational one, and has always been in use amongst civilized people—the worship of spirits is synonymous with barbarism—it is mere fetish.... There is something philosophic in the worship of the heroes of the human race.”
—George Borrow (1803–1881)
“Our children do not want models of perfection, neither do they want us to be buddies, friends, or confidants who never rise above their own levels of maturity and experience. We need to walk that middle ground between perfection and peerage, between intense meddling and apathy—the middle ground where our values, standards, and expectations can be shared with our children.”
—Neil Kurshan (20th century)