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.

Rational Expectations Theory

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.

Rational Expectations Theory

Definition