What is Rational Expectations Theory?
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The rational expectations theory is a concept and modeling technique that is used widely in macroeconomics. The theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences.The theory suggests that people’s current expectations of the economy are, themselves, able to influence what the future state of the economy will become. This precept contrasts with the idea that government policy influences financial and economic decisions.
Definition
Rational Expectations Theory is a concept and modeling technique widely used in macroeconomics. It posits that individuals make decisions based on three main factors: their human rationality, available information, and past experiences. The theory suggests that people's current expectations about the economy can themselves influence the future state of the economy. This principle contrasts with the view that government policies influence financial and economic decisions.
Origin
The Rational Expectations Theory originated in the 1960s, first proposed by economist John Muth. In the 1970s, Robert Lucas further developed the theory and applied it to macroeconomics, particularly in analyzing the effectiveness of monetary policy. Lucas's work, known as the "Lucas Critique" in 1976, had a profound impact on economic policy formulation.
Categories and Features
Rational Expectations Theory is mainly divided into two categories: micro-level rational expectations and macro-level rational expectations. Micro-level rational expectations focus on how individuals and firms make decisions in the market, while macro-level rational expectations focus on how the overall economy responds to policy changes. Its features include the assumption that individuals can fully utilize all available information and that their expectations are statistically correct.
Case Studies
A typical case is the United States in the 1970s, where monetary policy attempted to reduce unemployment by increasing the money supply. However, due to rising public expectations of inflation, the policy failed to achieve its intended effect. Another case is the European Central Bank's quantitative easing policy in the 2010s, which aimed to stimulate economic growth but had limited effects due to market participants' low expectations of long-term economic growth.
Common Issues
Common issues investors face when applying Rational Expectations Theory include overestimating or underestimating market participants' ability to process information and ignoring the impact of irrational factors on the market. A common misconception is that all market participants can perfectly predict the future, whereas, in reality, information asymmetry and psychological factors often lead to expectation biases.
