THE RATIONAL EXPECTATIONS REVOLUTION THEORY

– BY OYEKANMI DANIEL. A. (AEE/05/4928)

(SUBMITTED TO THE DEPT OF AGRIC ECONS & EXTENSION, SCHOOL OF AGRICULTURE,

FEDERAL UNIVERSITY OF TECHNOLOGY {AKURE} NIGERIA)

CONTENT:
1.0 INTRODUCTION
1.1 Definition
1.2 John Muth

2.0 RATIONAL EXPECTATIONS

2.1 The Model
2.1.1 The Lucas Critique
2.1.2 Dynamic Stochastic General Equilibrium (DSGE)
2.1.3 Advantages & Disadvantages
2.2 The Theory
2.2.1 Adaptive Expectations

3.0 CRITICISMS OF THE RATIONAL EXPECTATIONS

3.1 Falsifiability

4.0 CONCLUSION

5.0 REFERENCES

1. INTRODUCTION

The rational expectations theory is a revolutionary approach to macro-economics developed in the late
1970’s when it was viewed by many as radical, unlike today having attained a central position in macro-economic
theory and policy making.
In the 1970’s, the rational expectation school challenged the traditional Keynesian view of the world.
Economic models built on the ideas of Lord John Maynard Keynes treated the economy more or less as a system of
controllable inanimate objects blindly following rules. Models built on the ideas of rational expectations attempt to
acknowledge the ability of humans to change their behavior when they expect economic policies to change. The
repercussions of this dramatic shift in thought are still being felt among practicing macro-economic theorists and
policy makers.

1.1 DEFINITION
Rational expectations is an assumption in a model that the agent under study uses a forecasting mechanism
that is as good as is possible given the stochastic (random) processes and information available to the agent. Often
in essence, the rational expectations assumption is that the agent knows the model and fails to make absolutely
correct forecasts only because of the inherent randomness in the economic environment.
Muth (1960) puts forward his hypothesis “I should like to suggest that expectations, since they are informed
predictions of future events, are essentially the same as predictions of relevant economic theory. At the risk of
confusing this purely descriptive hypothesis with a pronouncement as to what firms ought to do, we call such
expectations rational”

1.2 JOHN MUTH

John Fraser Muth (1930 – October 23, 2005 in Keywest, Florida) was an American Economist. He is known
as ‘the father of the rational expectations revolution in economics’ primarily due to his article ‘Rational
Expectations and the Theory of Price Movements’ (1961).
Muth earned his PhD in Mathematical Economics from the Carnegie Mellon University and was in 1954 the
first recipient of the Alexander Henderson Award. He was affiliated with Carnegie Mellon as a research associate
professor without tenure from 1962 to 1964.
Although he formulated the rational expectations principle in the context of micro-economics, it has
subsequently become associated with macro-economics. Among Muth’s insights (1960) was that the stochastic
process being forecast should dictate both the distributed lag and the conditioning variable that people use to
forecast the future.

2. RATIONAL EXPECTATION REVOLUTION

2.1 THE MODEL

Rational expectations is an assumption used in many contemporary macro-economic models. Since most of
such models study decisions over many periods, the expectations of workers, consumers, and firms (all referred to
as agents) about future economic conditions are an essential part of the model. How to model these expectations has
long been controversial and it is well known that the macro-economic predictions of the model may differ
depending on the assumptions made about expectations.
To assume rational expectations is to assume that agents’ expectations are correct on the average. In other
words, although the future is not fully predictable, agents’ expectations are assumed not to be systematically biased
and use all relevant information in forming expectations of economic variables.
This way of modeling expectations was originally proposed by John F. Muth (1961) and was later to
become influential when used by Robert E. Lucas (of the famous Lucas critique) and others. Modeling expectations
is crucial in theories like new classical macro-economics, new Keynesian macro-economics and the efficient
market hypothesis of contemporary finance which studies the dynamics of the economy over time. 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 decisions to a major extent which cannot be overemphasized.

2.1.1 The Lucas Critique

The Lucas critique, named after Robert E. Lucas’ work on micro-economic policy making, says
that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships
observed in historical data.
The basic idea predates Lucas’ contribution, but in a 1976 paper, he drove home the point that this
simple notion invalidated policy advice based on conclusions drawn from an estimated system of equation models.
Because the parameters of those models were not structural i.e. policy invariant, they would necessarily change
whenever policy was changed. Policy conclusions drawn from these models would therefore be misleading. This
argument called into question the prevailing large scale econometric models that lacked the foundation of economic
theory.
The Lucas critique was influential not only because it cast doubt on many existing models, but also
because it encourages macro-economists to build micro-foundations for their models, which has always been
considered as desirable; Lucas convinced many economists that this was essential. Contemporary macro-economic
models micro-founded on the interaction of rational agents are often called Dynamic Stochastic Equilibrium
(DSGE) models. These are done in view of the Lucas Critique.
 2.1.2 Dynamic Stochastic General Equilibrium (DSGE)
DSGE is a branch of applied general equilibrium theory that is increasingly influential in
contemporary macro-economics. The DSGE methodology attempts to explain aggregate economic phenomena such
as economic growth, business cycles and the effects of monetary and fiscal policies on the basis of macro-economic
models derived from micro-economic principles. One of the main reasons macro-economists have begun to build
DSGE models is that unlike more traditional macro-econometric forecasting models, DSGE macro-economic
models should not, in principle, be vulnerable to the Lucas Critique.
2.1.2.1 Structure of the DSGE Model
As the name indicates, they are dynamic models studying how the economy evolves over time.
They are also called stochastic taking into account the fact that the economy is affected by random shocks such as
technological changes, fluctuations in oil prices, or errors in macro-economic policy making. This contrasts with
the static models studied in Walrasian general equilibrium theory, applied general equilibrium theory and
computable general equilibrium models.
Since DSGE models are technically more technically more difficult to solve and analyze, they
tend to abstract from so many sectoral details and include far fewer variables in theoretical DSGE papers or on the
order of a hundred variables in the experimental DSGE forecasting models.
What DSGE models give up in sectoral detail they attempt to make up for in logical consistency
because they are founded on micro-economic principles of constrained decision making. Since DSGE models must
therefore spell out the following aspects of the economy.
• Preferences: the objective of the agent in the economy must be specified. For example, the households
might be assumed to maximize a utility function over consumption and labor effort. Firms might as well be
assumed to maximize profit.
• Technology: the productive capacity of the agents in the economy must be specified. For example, firms
might be assumed to have a production function specifying the amount of goods to be produced depending
on the amount of capital and labor employed. Technological constraints on agents’ decisions might also
include costs of adjusting the capital stock, the level of employment of price level.
• Institutional Framework: the institutional constraints under which economic agents interact must be
specified. In many DSGE models, this might simply mean that agents make their choices within some
exogenously imposed budget constraints, and that prices are assumed to adjust until the market clears. It
might also mean specifying the rules of monetary change depending on a political process.

2.1.3 Advantages and Disadvantages

By specifying preferences (what agents want), technology (what the agents can produce), and
institution (the way they interact), it is possible to solve the DSGE model to predict what is actually produced,
traded and consumed.
In principle, it is possible to make valid predictions about the effects of changing the
institutional framework.
By contrast, as Robert Lucas pointed out, such a prediction is unlikely to be valid in traditional
macro-economic forecasting models since such models are based on observed past correlatives between macro-
economic variables. Their correlations can be expected to change when new policies are introduced,
invalidating predictions based on past observations.
Given the difficulty of constructing accurate DSGE models, most Central banks still rely on
traditional macro-economic models for short term forecasting. However, the effects of alternative policies are
increasingly studied using DSGE methods. Since DSGE models are constructed on the basis of assumptions
about agents’ preferences, it is possible to ask whether the policies considered are pareto optimal or how they
satisfy some other welfare derived from preferences.
2.1.3.1 Pareto Optimality
This is the movement from one allocation in income to another that can make at least one
individual better off without making another worse off.
 2.1.4 Schools of DSGE Modeling
At present, two competing schools of thought form the bulk of DSGE modeling:
• Real Business Cycle (RBC) theory builds on the neoclassical growth model, under the assumption of
flexible prices, to study how real shocks to the business economy might cause business cycle
fluctuations. Kydland and Prescot (1982) are often considered the starting point of the RBC theory and
of DSGE modeling in general.
• New Keynesian DSGE models build on a structure similar to RBC models, but instead assume that
prices are set by monopolistically competitive firms and cannot be simultaneously and costlessly
adjusted. The paper that first introduced this framework was Rotenberg and Woodford (1997).

2.2 THE THEORY

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. However, without further assumptions, this theory
of expectations determination makes no predictions about human behavior and it is empty. Thus, it is assumed that
outcomes that are being forecast do not differ systematically or predictably from equilibrium results i.e. it assumes
that people do not make systemic errors when predicting the future and derivations from perfect foresights are only
random. In an economic model, this is typically modeled by assuming that the expected value of a variable is equal
to the value predicted by the modeling, plus a random term representing the role of ignorance and mistake. 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 of expectations were formed. In other words, ex ante and
the actual price is equal to its rational expectation.
P = P* + e
E (P) = P*
Where P* is the rational expectation and e 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, if the economy suffers from constantly rising inflation rates
(perhaps due to government policies); people would be assumed always underestimate inflations. This may be
regarded as unrealistic – surely such individuals would sooner or later realize the trend and take it into account in
forming their expectations. Further, models of adaptive expectations never attain equilibrium, instead only moving
towards it asymptotically.
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 from the expected values.
The rational expectations hypothesis has been used to support some radical conclusions about economic
policy making. 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 policies,
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 unemployment. This is distinctly New Classical outcome. During
the 1970s, the rational expectations appeared to have made previous macro-economic theory largely obsolete which
culminated with the Lucas Critique. However, rational expectations theory has been widely adopted throughout
modern macro-economics as a modeling assumption thanks to the work of New Keynesian such as Stanley Fischer.
Rational expectations theory is the basis for the efficient market hypothesis (theory). If a security’s price
does not reflect all the information about it, then there exists ‘unexploited profit opportunities’: someone can buy
(or sell) the security to make a profit, thus driving the price towards 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 fundamental (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.
2.2.1 Adaptive Expectations
In economics, adaptive expectations means that people form their expectations about what will
happen in the future based on what has happened in the past. For example, if inflation has been higher than
expected in the past, people will revise their expectations of the future.
One simple version of adaptive expectations is stated in the following equations, where Pe is this
year’s rate of inflation that is currently expected; Pe-1 is this year’s rate of inflation that was expected last year; and P
is this year’s actual rate of inflation.
Pe = Pe-1 + ƛ (P-1 - Pe-1 )
Where ƛ is between 0 and 1 this says that current expectations of future inflation reflects past
expectations and an ‘error-adjustment’ term, in which current expectations are raised (or lowered), according to the
gap between actual inflation and previous expectations. This error adjustment is also called partial adjustment.
The theory of adaptive expectations which can be applied to all previous periods is that current
inflation expectations equal:
Pe = (1-ƛ)∞ ∞Ʃj=0(XjPj)
Where Pj equals actual inflation j years in the past. Thus, current expected inflation reflects a weighted average of
all past inflation; where the weights get smaller and smaller as we move further into the past.
Once a forecasting error is made by agents, due to a stochastic shock, they will be unable to
correctly forecast the price level again even if the price level experiences no further shocks since they only ever
incorporate part of their errors.
The background nature of expectation formulation and the resultant systematic errors made by
agents was unsatisfactory to economists such as John Muth, who was pivotal in the development of an alternative
model of how expectations are formed, called rational expectations. This has largely replaced adaptive
expectations in macro-economic theory since its assumptions of rationality is more consistent with economic
reality.

3. CIRTISMS OF THERATIONAL EXPECTATION THEORY

The hypothesis is often criticized as an unreal model of how expectations are formed. First, truly rational
expectations would take into account the fact that information about the future is costly. The ‘optimal forecast’ may
be the best, not because it is accurate but because it is too expensive to attain even close to accuracy.
Followers of the Austrian school and John Maynard Keynes go further, pointing to the fundamental
uncertainty about what will happen in the future. That is, the future cannot be predicted such that no expectations
can truly be “rational”.
Further, the models of Muth and Lucas (and the strongest version of the efficient market hypothesis) assume
that at any specific time, a market of the economy has only one equilibrium (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 theorists.
A further problem relates to the application of 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 rational 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 in the micro-level and lacks, in the sense, a micro-economic foundation.
 It can be argued that it is difficult to apply standard efficient market hypothesis (efficient market theory) to
understand the stock market bubble that ended in 2000 and collapsed thereafter. Advocates of rational expectations
may say that the pertinent effects of the stock market crash are a great challenge. Sociologists tend to criticize the
theory based on Philosopher Karl Popper’s criterion of falsifiability. They note that many economists, upon being
confronted with empirical data that goes against the ‘rational’ theory can simply modify their theories without ever
touching the basic theory of rational expectations. Furthermore, social scientists in general criticize the movement
of this theory into other fields such as political sciences. In his book ‘Essence of Decision’, political scientists
Graham T. Allison specifically attacked the rational expectations theory.
Philosophers have made similar arguments, claiming that the entire “rational expectations revolution
theory” was originated by Thomas Hobbes. A specific field of economics called behavioral economics has emerged
from those considerations of which Daniel Kahneman (Nobel Prize 2002) is one of the pioneers and main theorists.
3.1 Falsifiability
Otherwise known as refutability, it is the logical possibility that an assertion can be shown false by an
observation or a physical experiment. That something is falsifiable does not mean that it is false; rather that if it is
false, then it can be shown by observation or experiment.
Falsifiability is an important concept in economics and the philosophy of science. Some philosophers
and scientists, most notably Karl Popper (above), have asserted that a hypothesis, proposition or theory is scientific
only if it is falsifiable.

4. CONCLUSION
In spite of its shortcomings, the rational revolution expectations theory is still accepted and has attained a
central position in micro-economic theory and policy making. 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 “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 imply loss of feed back into 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.