The Theory of Rational

Expectations
This is the most widely used theory to describe the
formation of business and consumer expectations.

Economists regularly viewed expectations as formed

from past experience only.
Expectations of inflation, for example, were typically
viewed as being an average of past inflation rates.
This view of expectation formation, called adaptive
expectations, suggests that changes in expectations will
occur slowly over time.
 Cont.
• So if inflation had formerly been steady at a
5% rate, expectations of future inflation would
be 5% too. If inflation rose to a steady rate of
10%, expectations of future inflation would
rise toward 10%, but slowly: In the first year,
expected inflation might rise only to 6%; in the
second year, to 7%; and so on.
 Cont.
• Adaptive expectations have been faulted on the
grounds that people use more information than just
past data on a single variable to form their
expectations of that variable.
• Their expectations of inflation will also be affected by
their predictions of future monetary policy as well as
by current and past monetary policy. In addition,
people often change their expectations quickly in the
light of new information.
 Cont.
• John Muth (1961) developed an alternative
theory of expectations, called rational
expectations, which can be stated as
Expectations will be identical to optimal
forecasts (the best guess of the future) using
all available information.
 Cont.
• However, the forecast does not have to be
perfectly accurate to be rational—it need only
be the best possible given the available
information; that is, it has to be correct on
average.
• Even though a rational expectation equals the
optimal forecast using all available
information, a prediction based on it may not
always be perfectly accurate.
 Cont.
• What if an item of information relevant to predicting
is unavailable or ignored?
• If one has no way of ascertaining new information,
his expectation is still rational, because the new
information is not available to him for incorporation
into his optimal forecast.
• However, if he did not bother or ignored the new
information, his expectation is no longer rational.
 Cont.
• Accordingly, there are two reasons why an
expectation may fail to be rational:
1. People might be aware of all available information
but find it takes too much effort to make their
expectation the best guess possible.
2. People might be unaware of some available
relevant information, so their best guess of the
future will not be accurate.
 Cont.
• Nonetheless, it is important to recognize that
if an additional factor is important but
information about it is not available, an
expectation that does not take account of it
can still be rational.
 Cont.
• the theory of rational expectations:. If X
stands for the variable that is being forecast,
Xe for the expectation of this variable, and Xof
for the optimal forecast of X using all available
information,
Xe = Xof
 The Rational Behind the Theory
• Why do people try to make their expectations match
their best possible guess of the future using all
available information? The simplest explanation is
that it is costly for people not to do so.
• For Example, an appliance manufacturer
knows that interest-rate movements are important
to the sales of appliances. If the firm makes poor
forecasts of interest rates, it will earn less profit,
because it might produce either too many appliances
or too few.
 Cont.
• There are strong incentives for the firm to
acquire all available information to help it
forecast interest rates and use the
information to make the best possible guess
of future interest rate movements.
 Cont.
• In financial markets, people with better
forecasts of the future get rich. The
application of the theory of rational
expectations to financial markets is called the
efficient market hypothesis or the theory of
efficient capital markets)
 Implications of the Theory

• Rational expectations theory leads to two

commonsense implications for the forming of
expectations that are important in the analysis of the
aggregate economy:
1. If there is a change in the way a variable moves,
the way in which expectations of this variable are
formed will change as well.
 Cont.
• Suppose that interest rates move in such a
way that they tend to return to a “normal”
level in the future. If today’s interest rate is
high relative to the normal level, an optimal
forecast of the interest rate in the future is
that it will decline to the normal level.
Rational expectations theory would imply that
when today’s interest rate is high, the
expectation is that it will fall in the future.
 Cont.
• Suppose now that the way in which the
interest rate moves changes so that when the
interest rate is high, it stays high. In this case,
when today’s interest rate is high, the optimal
forecast of the future interest rate, and hence
the rational expectation, is that it will stay
high. Expectations of the future interest rate
will no longer indicate that the interest rate
will fall.
 Cont.
2. The forecast errors of expectations will on average
be zero and cannot be predicted ahead of time. The
forecast error of an expectation is X - X e, the
difference between the realization of a variable X
and the expectation of the variable; that is, if the
interest rate on a particular day is 4% and the
expectation is 3.5%, the forecast error is 0.5%.
 Cont.
• Suppose that in violation of the rational expectations
tenet, the forecast error is not, on average, equal to
zero; instead, it equals 0.5%. The forecast error is
now predictable ahead of time because the person
will soon notice that interest rate, on average, 0.5%
higher and can improve his forecast by increasing it
by 0.5%.
• Rational expectations theory implies that forecast
errors of expectations cannot be predicted.
 The Efficient Market Hypothesis:

• The efficient market hypothesis is based on

the assumption that prices of securities in
financial markets fully reflect all available
information.
• Re = Rof (expected return is the optimal
forecast of return using all available
information)
 Cont.
• Re = R*
• The expected return on a security Re equals the
equilibrium return R*, which equates the quantity of
the security demanded to the quantity supplied.
• We can derive an equation to describe pricing
behavior in an efficient market by using the
equilibrium condition to replace Re with R* in the
rational expectations equation. In this way, we
obtain: Rof = R*
 Cont.
• This equation tells that current prices in a
financial market will be set so that the optimal
forecast of a security’s return using all
available information equals the security’s
equilibrium return.
• According to Financial economists: In an
efficient market, a security’s price fully reflects
all available information.
 Rationale Behind
the Hypothesis
• Suppose that the equilibrium return on a security—
say, Exxon common stock—is 10% at an annual rate,
and its current price Pt is lower than the optimal
forecast of tomorrow’s price Pt+1 so that the optimal
forecast of the return at an annual rate is 50%, which
is greater than the equilibrium return of 10%.
• We are now able to predict that, on average, Exxon’s
return would be abnormally high. This situation is
called an unexploited profit opportunity.
 Cont.
because Rof is greater than R*, you would buy more,
which would in turn drive up its current price Pt
relative to the expected future price P t+1, thereby
lowering Rof. When the current price had risen
sufficiently so that Rof equals R* and the efficient
markets condition is satisfied, the buying of Exxon
will stop, and the unexploited profit opportunity will
have disappeared.
 Cont.
• Similarly, a security for which the optimal forecast of
the return is 5% and the equilibrium return is 10%
(Rof is smaller than R*) would be a poor investment,
because, on average, it earns less than the
equilibrium return. In such a case, you would sell the
security and drive down its current price relative to
the expected future price until Rof rose to the level
of R* and the efficient markets condition is again
satisfied.
Cont.
 Cont.
• In an efficient market, all unexploited profit
opportunities will be eliminated.
• A very important factor in this reasoning is that not
everyone in a financial market must be well informed
about a security or have rational expectations for its
price to be driven to the point at which the efficient
markets condition holds.
 Cont.
• Financial markets are structured so that many
participants can play. As long as a few keep
their eyes open for unexploited profit
opportunities, they will eliminate the profit
opportunities that appear, because in so
doing, they make a profit.