Rational Expectations
Under rational expectations, people form forecasts using all available information, so their forecasts are not systematically wrong. Errors happen, but they are random rather than predictable. This idea is the engine under the efficient markets hypothesis.
Why it matters
If a forecasting mistake were predictable, people would learn from it and stop making it. What survives is a forecast that is right on average, with leftover errors that no one could have anticipated.
Worked examples
Markets widely expect the central bank to cut rates at its next meeting. What does rational expectations imply for asset prices today?
The expected cut is already reflected in today’s prices. Only a surprise, such as no cut at all, would move prices when the decision is announced.
Common mistakes
- ✗Rational expectations means everyone has perfect foresight. Forecasts can be wrong. They are just not wrong in a predictable, repeatable way.
- ✗Simply extrapolating the past (adaptive expectations) is the same thing. Adaptive expectations are backward-looking and can be systematically wrong when conditions change.
Revision bullets
- •Forecasts use all available information
- •Errors are random, not systematic
- •Underpins the efficient markets hypothesis
Quick check
Rational expectations allows a forecast to be
Connected topics
Sources
- Mishkin (2018), Ch. 7Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The theory of rational expectations and its contrast with adaptive expectations.