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What are Rational Expectations?

Karize Uy
Karize Uy

"Rational expectations" is the name of a hypothesis in economics stating that an outcome is hugely dependent on what people are expecting to happen in the future. The people’s expectations are fueled by previous economic situations and information that is available and relevant. This economic hypothesis also considers the general public to be an important economic agent, as opposed to considering only the government and its policies as the major players in changing economic outcomes.

John Muth conceptualized the notion of rational expectations in 1961, when he wrote an article entitled “Rational Expectations and the Theory of Price Movements.” The economic hypothesis was Muth’s counter-response to a contemporaneous concept called adaptive expectations. The common ground for both theories is that people adapt to change and learn from experience, but adaptive expectations asserts that people gradually adapt after a certain situation, in contrast to rational expectations' idea that people have the ability to rapidly learn and simultaneously adapt to economic situations as they are taking place. Muth’s hypothesis later became prominent after other economists such as Robert Lucas Jr., Edward Prescott and Neil Wallace made use of it.

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In rational expectations, the two elements, outcome and expectation, feed and affect each other. What people are anticipating to happen will be the driving force behind their future actions, which, in turn will shape the outcome. The present outcome, on the other hand, will create a new expectation, and the cycle will continue. In currency rates, for example, if people expect a depreciation of a certain currency, this will lead them to pull out of their investments, which will cause that currency to decrease in value.

On a larger scale, an individual’s expectation can also sway another individual’s expectation, triggering a collective expectation for a situation. This makes for a greater probability that an expectation will be realized. In this way, rational expectations believes that a certain economic outcome does not significantly diverge from what people are expecting to happen, making the theory a model-consistent expectation. This belief is applied to applied mathematics, particularly in game theory, which states that a person relies on anticipating other people’s choices in order to be successful in any situation that requires strategy.

Based on the term itself, rational expectation also presumes that people act in a manner that makes the most out of their resources and profits. Another theory is called the rational choice theory. It applies this presumption by affirming that people typically make choices to increase their profits while reducing costs.

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