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Rational Expectations Theory

Definition

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models.

What is the 'Rational Expectations Theory'

The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in the economy are equivalent to what people think the future state of the economy will become. This contrasts with the idea that government policy influences people's decisions.

Explaining 'Rational Expectations Theory'

The rational expectations theory is often used to explain expected rates of inflation. For example, if inflation rates within an economy were higher than expected in the past, people take that into account along with other indicators to assume that inflation may further increase in the future.

An Example of Rational Expectations Theory

Rational expectations theory, while valid, can sometimes have adverse effects on the global economy. For example, Former Bank of England governor Mervyn King has pointed out that central banks can easily become a prisoner of the economy's rational expectations theory.


Further Reading


A rational expectations theory of kinks in financial reporting
meridian.allenpress.com [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

Shackle and Keynes vs rational expectations theory on the role of time, liquidity and financial marketsShackle and Keynes vs rational expectations theory on the role of time, liquidity and financial markets
link.springer.com [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

Common agency with rational expectations: Theory and application to a monetary unionCommon agency with rational expectations: Theory and application to a monetary union
academic.oup.com [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

The significance of rational expectations theoryThe significance of rational expectations theory
www.tandfonline.com [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

Dynamic optimal taxation, rational expectations and optimal controlDynamic optimal taxation, rational expectations and optimal control
www.sciencedirect.com [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

Generalized instrumental variables estimation of nonlinear rational expectations modelsGeneralized instrumental variables estimation of nonlinear rational expectations models
www.jstor.org [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

Rational expectations and macroeconomics in 1984Rational expectations and macroeconomics in 1984
www.jstor.org [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …

A rational expectations model of financial contagionA rational expectations model of financial contagion
onlinelibrary.wiley.com [PDF]
… Investors rationally interpret the reported earnings in formulating their beliefs and set the price accordingly … earnings levels—zero earnings, last year's earn- ings (zero change), and analysts' consensus expectation … A Rational Expectations Theory of Kinks in Financial Reporting …



Q&A About Rational Expectations Theory


How does the rational expectations theory differ from other economic theories?

Rational expectations theory differs from other economic theories because it suggests that government policy does not influence people's decisions.

What is rational expectations theory?

Rational expectations theory is a model-consistent expectations theory.

How do agents use all relevant information in forming their expectations of economic variables?

Agents use all relevant information to form their predictions.

What does "on average" mean in this context?

On average, over time, agents' predictions are correct.

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