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Rational Expectations

Rational Expectations

Imagine the Federal Reserve is deciding to pursue an expansionary monetary policy. You know that this will increase the price level in the economy. Most people would demand higher wages. How would you react when you find out that the government is pursuing an expansionary monetary policy? Would you ask your boss to increase your salary?

According to rational expectations, you would ask your boss to increase your salary as you make the optimal choice with all the available information. But does this happen with everyone? What are rational expectations, and how do they impact our economy?

You'll find out the answer to these questions and much more by reaching the bottom of this article!

Rational Expectations Definition

Before jumping into the definition of rational expectations, let's start with a bit of history!

In the 1970s, a concept known as rational expectations exerted a significant amount of influence on the field of macroeconomics. John Muth first presented the theory of rational expectations in 1961.1

Rational expectations mean that economic agents make optimum decisions by utilizing all of the information that is available to them.

When employees and employers negotiate long-term pay contracts, for instance, they must consider the anticipated inflation rate throughout the contract's duration. According to the theory of rational expectations, when estimating future rates of inflation, economic agents won't only look at previous inflation rates but also take into consideration the information that is now available regarding monetary and fiscal policies.

Imagine for a moment that prices did not go up during the previous year but that the monetary and fiscal policies that policymakers have revealed have made it very plain that there would be significant inflation for the next several years.

Although prices have not yet increased, it is reasonable to assume that long-term salary contracts will be revised today to take into account this future inflation. That's because workers will demand their optimal choice based on all the available information they have at hand.

Rational expectations and the stock market

A major application of rational expectations is considered to be in the stock market. Investors will purchase equities in which they anticipate a return greater than the market average while selling stocks in which they expect returns lower than the market average.

When investors do this, the prices of stocks that are anticipated to have higher than average returns are bid up, while the prices of stocks that are anticipated to have returns that are lower than average are driven down.

The prices of the stocks will continue to adjust until the expected returns, after considering the level of risk associated with each stock, are equivalent.

Rational Expectations Theory

The rational expectations theory started when John Keynes argued that the expectations individuals have about the future were capable of influencing the economy. That is to say that people were adjusting their economic decisions based on what they expected the economy's future to be like, which in turn, affected the state of the economy at that time.

The ideas and arguments of Keynes were further developed into what is known today as the rational expectations theory by John F. Muth in 1961.

According to the theory of rational expectations, people's expectations about the economy's future can influence the state of the economy in the present.

An example of future expectations affecting the current state of the economy is when workers expect higher inflation rates in the future periods. As a result, they demand higher wages to compensate for future purchasing power loss. The wage increase then causes the production cost to increase, leading to higher prices.

Rational Expectations Monetary Policy

Rational expectations play an important role when considering the impacts of monetary policy. Accepting the rational expectations assumption can bring about considerable shifts in perceptions about the efficacy of aggressive macroeconomic policy.

Previous theories, such as the natural rate hypothesis, suggest that the government can influence real economic variables such as total output produced and the unemployment rate in the economy, at least in the short run.

On the other hand, rational expectations bring about another view on monetary policy. The rational expectations suggest that monetary policy does not impact real variables such as total output produced or the unemployment rate.

That's because individuals will demand higher wages immediately when expecting an increase in inflation, which would increase the cost of production and the price level. Additionally, the increase in wages would not contribute to lowering unemployment due to the increase in production costs.

According to rational expectations, there is no short-run or long-run effect of monetary policies on real variables such as GDP or unemployment rate. Rather, there is an exclusive impact on the price level in the economy.

Rational Expectations Equilibrium

We can use the AD-AS model framework to understand the rational expectation equilibrium.

We have a detailed explanation of the AD-AS model. Feel free to check it out!

The AD-AS model is an economic model that shows the relationship between the price level and real output produced in the economy.

We've considered the fact that rational expectations imply that macroeconomic policy does not affect real variables such as GDP or unemployment. Still, they do have an impact on nominal variables such as the price level.

Rational expectations imply that people make optimal choices based on all the information they have available at hand.

Take a look at Figure 1 below.

Rational Expectations Rational expectations equilibrium shown on a graph StudySmarterFig. 1 - Rational expectations equilibrium

Figure 1 shows the economy which is in equilibrium at point 1, where the aggregate demand (AD1), short-run aggregate supply (SRAS1), and long-run aggregate supply (LRAS) intersect with one another. At point 1 of equilibrium, there is a Y1 level of goods and services produced, and the overall price level is at P1.

Now assume that the Federal Reserve decides to pursue an expansionary monetary policy. To do so, it chooses to lower the discount rate. This drops the interest rate in the economy, making borrowing money cheaper. As a result, consumption increases, which shifts the aggregate demand curve to the right (from AD1 to AD2). This contributes to an increase in the price level (from P1 to P2), and the output produced increases from Y1 to Y2.

However, due to rational expectations assumption, when individuals find out that there will be expansionary monetary policy and higher inflation, they will demand higher wages. The increase in wages increases firms' production costs, leading to a shift to the left of the short-run aggregate supply from SRAS1 to SRAS2. This brings the equilibrium to point 3, where there is a higher price level (inflation), and output remains the same.

Although we've shown a step by step equilibrium adjustment, due to rational expectations, the equilibrium goes directly from point 1 to point 3 instead of point 2. As a result of rational expectations, there is no short-run or long-run change in the overall output produced.

Rational Expectations vs. Adaptive Expectations

To understand rational expectations vs. adaptive expectations, let's consider the meaning of adaptive expectations.

Adaptive expectations mean that economic agents make expectations about future outcomes based on outcomes of similar events that have happened in the past.

The main difference between rational expectations and adaptive expectations is that adaptive expectations make use of historical information or information from the preceding period. On the other hand, rational expectations make use of all the available information, past and present, to make a decision.

Predicting inflation is possible with the help of adaptive expectations. People often anticipate a higher rate of inflation in the year after one in which there was a rise in the overall level of inflation.

When there is a discrepancy between what people anticipate will happen and what does take place, those people's expectations about any given variable will shift. On the other hand, if what they expected turned out to be accurate, it is unlikely that they would adjust their expectations in the future. Adaptive expectations require that individuals update their expectations as each period passes.

Rational Expectations - Key takeaways

  • Rational expectations mean that economic agents make optimum decisions by utilizing all of the information that is available to them.
  • According to rational expectations:
    • people's current economic expectations may influence the economy's future status;
    • there is no short-run or long-run effect of monetary policies on real variables such as GDP or unemployment rate.
  • Adaptive expectations mean that economic agents make expectations about future outcomes based on outcomes of similar events that have happened in the past.
  • The main difference between rational expectations and adaptive expectations is that rational expectations make use of all the available information, past and present.

References

  1. John F. Muth, Rational Expectations and the Theory of Price Movements, https://www.parisschoolofeconomics.eu/docs/guesnerie-roger/muth61.pdf

Frequently Asked Questions about Rational Expectations

Rational expectations is the idea that people and companies make optimal choices by utilizing all of the information that is available to them.

John F. Muth

The main difference between rational expectations and adaptive expectations is that rational expectations make use of present information. On the other hand, adaptive expectations make use of historical information.

No change in real variables such as GDP, but only change in nominal variables such as the price level.

Because it believes that the fiscal and monetary policies don't have short-run or long run-effect on the economy.

Final Rational Expectations Quiz

Question

Define rational expectations.

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Answer

Rational expectations is the idea that people and companies make optimal decisions by utilizing all of the information that is available to them.

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Question

According to the theory of rational expectations, when estimating future rates of inflation, economists won't only look at previous inflation rates but also take into consideration the information that is now available regarding monetary and fiscal policy.  

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Answer

True

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Question

According to rational expectations, an increase in inflation rate will cause wages to _____ ?

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Answer

Rise

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Question

According to the rational choice theory humans base their choices on ______ primary considerations.

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Answer

three

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Question

What are the three considerations humans base their choices on?

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Answer

  • Their own human reason.
  • The knowledge that is readily accessible to them.
  • The experiences that they have had in the past.

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Question

Can people's present expectations about the condition of the economy influence the future state of the economy?

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Answer

Yes

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Question

According to the rational expectations theory the government is incapable of influencing individual's economic decision?

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Answer

True

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Question

According to the rational expectations, an increase in money supply can increase the real output produced in an economy.

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Answer

False

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Question

Who was the first economist to bring up rational expectations?

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Answer

John Maynard Keynes

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Question

According to rational expectations, there is no short-run or long-run effect of monetary policies on real variables such as _____. 

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Answer

GDP

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Question

According to the rational expectations theory, monetary policy can only influence __________.

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Answer

Price level

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Question

What is the AD-AS model?

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Answer

The AD-AS model is an economic model that shows the relationship between the price level and real output produced in the economy.

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Question

Which economic model is used to explain rational expectations equilibrium?

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Answer

AD-AS model

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Question

What are adaptive expectations?

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Answer

Adaptive expectations argue that people make expectations about future outcomes based on outcomes of similar events that have happened in the past.

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Question

What is the main difference between adaptive expectations and rational expectations?

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Answer

The main difference between rational expectations and adaptive expectations is that rational expectations make use of present information. On the other hand, adaptive expectations make use of historical information.


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