What is Rational Expectation?
Rational expectation is an economic term which dictates how people, groups, organizations and states make economic decisions based on their reasonable assumptions about the future. According to the theory, people are expected to make decisions based on an unbiased expectation of the future and not rely on past events or random guesses.
The concept of rational expectation has its origin in the post World War II era, when academics and policymakers insisted on a new approach to economics. Pioneers John Muth and Robert Lucas argued that it would be inappropriate to assume that economic outcomes depended solely on past events, or that economic actors make decisions which are completely irrational. They argued that economic decisions can be analysed on the basis of the economic behaviour of individual actors, who are likely to make decisions that reflect their own knowledge and understanding. The result was the rational expectation theory, which holds that economic decision-makers have accurate expectations about the future economic state and make decisions based on those expectations.
So how exactly does this work? The theory proposes that individuals have access to the same resources, information and data as others, which means that they can form rational expectations about the future. This information is used to influence their decisions. For example, if an individual purchases a share of a company, the expectations of an increase in the value of that company would be based on availability of information about the company and its past performance. Similarly, the expectations about the future value of a country’s currency would be based on available information about political and economic conditions in that country.
The theory also impressed upon academics and policymakers the importance of accounting for the expectations of economic actors in economic models. Economic models that do not take into account the expectations of economic actors will not be able to provide an accurate description of economic outcomes. This idea is essential when it comes to forecasting economic situations. For example, economic forecasts that take account of the expected performance of the stock market, consumer confidence and changes in the job market generally provide more accurate predictions.
Although rational expectation theory has helped to explain many economic outcomes, it is still not without criticism. Some economists have argued that the theory overemphasizes the importance of expectations in influencing economic decisions and fails to take into account other factors. Furthermore, some economists have argued that the theory is no longer as applicable today as it was at the time of its inception because of technological advances, which have allowed for a more information-rich environment.
In spite of its criticism, rational expectation theory remains a central part of the economics discipline, and is used by economists to understand and analyse economic trends and patterns. It is also an important concept in macroeconomics, as it allows potential investors to assess economic conditions more accurately and make more informed decisions.
All in all, rational expectation theory is an important economic framework that helps us understand economic behaviour. By providing a framework of rational decision-making, the theory can be used to better predict future economic outcomes. As the world’s economies become ever more interconnected, this concept has become even more important in helping economists assess the impact of individual economic policies.
