Rational Expectations

In financial matters, “Levelheaded Expectations” are model-steady desires, in that specialists inside the model by and large accept the model’s forecasts are substantial. Objective desires guarantee inward consistency in total stochastic models. To get consistency inside a model, the forecasts without bounds estimation of financially important variables are ideal given the leaders’ data set and model structure. The reasonable desires suspicion is utilized particularly as a part of numerous contemporary macroeconomic models. Normal desires does not infer singular sanity and ought not be mistaken for judicious decision hypothesis, which is utilized widely as a part of, among others, amusement hypothesis.

Since most macroeconomic models today concentrate on choices over numerous periods, the desires of laborers, customers and firms about future financial conditions are a fundamental part of the model. Instructions to demonstrate these desires has for quite some time been disputable, and it is notable that the macroeconomic forecasts of the model may vary contingent upon the suppositions made about desires (see Cobweb model). To accept balanced desires is to expect that operators’ desires might not be right, however are right overall after some time. At the end of the day, despite the fact that what’s to come is not completely unsurprising, specialists’ desires are accepted not to be deliberately one-sided and utilize all applicable data in shaping desires of financial variables.

This way of modeling expectations was originally proposed by John F. Muth (1961) and later became influential when it was used by Robert 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.

Deirdre McCloskey emphasized that “rational expectations” is an expression of intellectual modesty: “Muth’s notion was that the professors of economics, even if correct in their model of man, could do no better in predicting than could the hog farmer or steelmaker or insurance company. The notion is one of intellectual modesty. The common sense is “rationality”: therefore Muth called the argument “rational expectations”.”

Theory: Common sense version

Rational expectations theory defines this kind of expectations as being identical to the best guess of the future (the optimal forecast) that uses all available information. Thus, it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. As a result, rational expectations do not differ systematically or predictably from equilibrium results. That is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random. In an economic model, this is typically modelled by assuming that the expected value of a variable is equal to the expected value predicted by the model.

For example, suppose that P is the equilibrium price in a simple market, determined by supply and demand. The theory of rational expectations says that the actual price will only deviate from the expectation if there is an ‘information shock’ caused by information unforeseeable at the time expectations were formed. In other words, ex ante the price is anticipated to equal its rational expectation:

where P* is the rational expectation and ε  is the random error term, which has an expected value of zero, and is independent of P*.

Rational expectations theories were developed in response to perceived flaws in theories based on adaptive expectations. Under adaptive expectations, expectations of the future value of an economic variable are based on past values. For example, people would be assumed to predict inflation by looking at inflation last year and in previous years. Under adaptive expectations, if the economy suffers from constantly rising inflation rates (perhaps due to government policies), people would be assumed to always underestimate inflation. Many economists have regarded this as unrealistic, believing that rational individuals would sooner or later realize the trend and take it into account in forming their expectations.

The hypothesis of rational expectations addresses this criticism by assuming that individuals take all available information into account in forming expectations. Though expectations may turn out incorrect, they will not deviate systematically from the realized values.

The rational expectations hypothesis has been used to support some strong conclusions about economic policymaking. An example is the Policy Ineffectiveness Proposition developed by Thomas Sargent and Neil Wallace. If the Federal Reserve attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly. This in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate, not employment. This is a distinctly New Classical outcome. During the 1970s rational expectations appeared to have made previous macroeconomic theory largely obsolete, which culminated with the Lucas critique. However, rational expectations theory has been widely adopted as a modelling assumption even outside of New Classical macroeconomics thanks to the work of New Keynesians such as Stanley Fischer. See f.e. Robert Skidelsky: The Return of the Master.

Of course, these economic policy consequences should be evaluated carefully. The relevance of this and other new classical theses is evident, but these theories should always be regarded as conditional statements. It means, for example, that the policy ineffectiveness hypothesis mentioned above is valid only under specific conditions, i.e. when the presumptions of the theory (such as perfect rationality or instant flexibility of prices) hold in reality. So new classical theorists could clearly specify the conditions under which traditional discretional economic policy can be effective again. If agents do not (or cannot) form rational expectations or if prices are not completely flexible, discretional and completely anticipated economic policy actions can trigger real changes.

Rational expectations theory is the basis for the efficient market theories. If a security’s price does not reflect all the information about it, then there exist “unexploited profit opportunities”: someone can buy (or sell) the security to make a profit, thus driving the price toward equilibrium. In the strongest versions of these theories, where all profit opportunities have been exploited, all prices in financial markets are correct and reflect market fundamentals (such as future streams of profits and dividends). Each financial investment is as good as any other, while a security’s price reflects all information about its intrinsic value.

Theory: Experts’ version

The Rational Expectations Hypothesis is about endogenous expectation formation, not exogenous. Endogenous expectation formation means that the expectations are modeled and disseminated, contrary to expectations that are formed by the holders of them. The modeling is done by economists, and the expectations are disseminated using communications technology. Keynes held expectations as exogenous, but monetarists like Friedman and his followers hold expectations endogenous. The ingenuity of endogenous expectations is that it makes possible to control human behavior using induced expectations, since ideas about future events affect current behavior. This is the idea in Carnegie decision making model and Rational Expectations. Different expectations mean different kind of futures. The Certainty Equivalence approach operates this way ignoring and adding uncertainty. See f.e. Soros, George: The Crisis of Global Capitalism: Open Society Endangered, for a short notion about this principle.

Selecting the expectations held by individuals mean choosing between alternative futures. Alan A. Walters uses the concept of Consistent Expectations instead of Rational Expectations, because consistency describes better model-consistent expectations than rationality. Rational Expectations can be totally irrational for the holder of them. This is the idea when Francis Fukuyama claims that it is possible for a human being to fail in surviving. Rational Expectations, that is Consistent Expectations Hypothesis, operates on a biopolitical basis since according to David Hume a human being can not be without expecting. This is not the only level of biopolitics, since newer mechanisms use electrical and medical means. So there is a kind of back-up when the Rational Expectations model fail to work. An interesting detail is that John Muth translates “choris syndesi”, “without link”.

Franco Modigliani has used the concept of full-blown rational expectations. The consistency instead of rationality notion means that the claims behind the modeled expectations do not have to be true. George: The Crisis of Global Capitalism: Open Society Endangered, for a notion about about Rational Expectations, the expansion of the thinking, analysis of Karl Popper’s legacy, and a notion about random walk. The Rational Expectations economy uses “superimposed” noise to create an illusion of random walk, shown in a paper connected to name John F. Muth.

Criticisms

Rational expectations are expected values in the mathematical sense. In order to be able to compute expected values, individuals must know the true economic model, its parameters, and the nature of the stochastic processes that govern its evolution. If these extreme assumptions are violated, individuals simply cannot form rational expectations

The models of Muth and Lucas (and the strongest version of the efficient-market hypothesis) assume that at any specific time, a market or the economy has only one equilibrium (which was determined ahead of time), so that people form their expectations around this unique equilibrium. Muth’s math (sketched above) assumed that P* was unique. Lucas assumed that equilibrium corresponded to a unique “full employment” level (potential output) – corresponding to a unique NAIRU or natural rate of unemployment. If there is more than one possible equilibrium at any time then the more interesting implications of the theory of rational expectations do not apply. In fact, expectations would determine the nature of the equilibrium attained, reversing the line of causation posited by rational expectations economists.

A further problem relates to the application of the rational expectations hypothesis to aggregate behavior. It is well known that assumptions about individual behavior do not carry over to aggregate behavior. The same holds true for rationality assumptions: Even if all individuals have rational expectations, the representative household describing these behaviors may exhibit behavior that does not satisfy rationality assumptions (Janssen 1993). Hence the rational expectations hypothesis, as applied to the representative household, is unrelated to the presence or absence of rational expectations on the micro level and lacks, in this sense, a microeconomic foundation.

It can be argued that it is difficult to apply the standard efficient-market hypothesis (efficient market theory) to understand the stock market bubble that ended in 2000 and collapsed thereafter; however, advocates of rational expectations say that the problem of ascertaining all the pertinent effects of the stock-market crash is a great challenge.

Furthermore, social scientists have criticized the movement of rational choice theory into other fields such as political science. In his book Essence of Decision, political scientist Graham T. Allison specifically attacked applications of rational choice theory. This should not be confused with rational expectations theory.

Some economists now use the adaptive expectations model, but then complement it with ideas based on the rational expectations theory. For example, an anti-inflation campaign by the central bank is more effective if it is seen as “credible,” i.e., if it convinces people that it will “stick to its guns.” The bank can convince people to lower their inflationary expectations, which implies less of a feedback into the actual inflation rate. (An advocate of Rational Expectations would say, rather, that the pronouncements of central banks are facts that must be incorporated into one’s forecast because central banks can act independently). Those studying financial markets similarly apply the efficient-markets hypothesis but keep the existence of exceptions in mind.

Maurice Allais’s Hereditary, Relativist and Logistic (HRL) theory of monetary dynamics contains an original theory of expectations formation that is a genuine alternative to both adaptive and rational expectations. Praised by Milton Friedman in 1968 with the following words: This work introduces a very basic and important distinction between psychological time and chronological time. It is one of the most important and original paper that has been written for a long time … for its consideration of the problem of the formation of expectations.” Allais’s contribution has nevertheless been “lost”: it has been absent from the debate about expectations.

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