Rational Expectation Theory

What It Means

“Rational expectation theory” refers to an idea in economics that is simple on the surface: people use rationality, past experiences, and all available information to guide their financial decision-making. The implications of the idea are more complex, however. When applied on a macroeconomic level (that is, when considered as a factor in the economy as a whole), rational expectation theory leads to the conclusion that people’s current expectations about the economy will themselves influence the future course of the economy.

This idea, though originated in the 1960s, revolutionized economics in the 1970s. At that time government economic policies were largely based on the theories of John Maynard Keynes, who believed that governments could and should make adjustments to the economy using fiscal policy (taxes and government spending) and monetary policy (changes in the money supply). When viewed through the lens of rational expectation theory, however, government attempts to control the economy are bound to be ineffective. This is because individuals, according to the theory, will anticipate the effects of the government’s actions and adjust their own decision-making accordingly, nullifying the policies’ intended effects. Between the mid-1970s and the mid-1990s, in large part due to rational expectation theory, Keynesian theories about the economy were in decline. New classical economics, heavily reliant on rational expectation theory, became the dominant school of economic thought during that time.

When Did It Begin

Early twentieth-century economists, including Keynes himself (whose landmark work, The General Theory of Employment, Interest, and Money, was published in 1936) were aware of the power that people’s expectations exerted on the economy. It was not until the early 1960s, though, that this knowledge began to be thoroughly applied to the economy in the form of rational expectation theory. The theory was first outlined by John F. Muth, an economist at Indiana University, in 1961. The economist most associated with the rise to prominence of rational expectation theory is Robert E. Lucas, who taught at Carnegie Mellon University and the University of Chicago. Lucas was responsible for using rational expectation theory to critique Keynesian notions of government spending.

More Detailed Information

Rational expectation theory arose from considerations of the numerous economic situations in which people’s expectations play a role in determining the outcome. The stock market is one such economic situation. If large numbers of investors begin to believe that Wal-Mart stock will lose value in the future, they will be likely to sell their Wal-Mart stock. This causes the price of Wal-Mart stock to fall. In other words, a stock’s price is in large part determined by what people expect that stock’s price to be in the future.

Similarly, the farming industry is greatly affected by people’s expectations. Farmers determine how much corn to plant according to the price they can expect to get when they sell their corn; at the same time, corn prices are determined in part by how much corn farmers decide to plant. On both sides of this situation, with both buyers and sellers of corn, rational expectations influence the economic outcome.

When people base economic decisions on expectations, it is strongly in their interest to build those expectations on sound evidence. The investor who trades stocks based on thorough research into a company’s future is more likely to profit from trades than someone who trades based on superstitions. In addition, people tend to build up expertise in predicting future stock prices. They watch the price of a given stock in various conditions, and become better able to predict how that stock will perform when those conditions recur. Over time, savvy investors adjust their decisions based on a wealth of past experience. The future tends to grow out of the past in predictable ways, allowing people to make surprisingly accurate collective predictions.

Rational expectation theory thus suggests that economic outcomes will generally be what people predict them to be. Economists who believe in rational expectation theory do not maintain that people always make accurate predictions. They do maintain, however, that the collective predictions of economic decision makers will not be consistently wrong over the long term.

Recent Trends

Keynesian theories urging government fine-tuning of the economy dominated economics from the 1930s until the 1970s. In the 1950s and 1960s “monetarists” such as Milton Friedman argued that Keynesians did not fully account for the effects of the money supply on the economy. Rather than ending the reign of Keynesian economics, this critique resulted in a compromise school of thought known as the neoclassical synthesis. Keynesian theories came under further attack because they failed to account for an unprecedented phenomenon known as stagflation (high prices coupled with high unemployment), which occurred in the 1970s. But it was rational expectation theory, as applied to government intervention in the economy, that provided the most serious critique of Keynesian theory among mainstream economists.

The economist Robert E. Lucas was responsible for challenging Keynesian theories of government intervention using rational expectation theory. He argued that people will always predict the effects of government economic policy before those policies can take effect. Therefore, policies might add “noise” to the economy (that is, activity that is essentially meaningless), but they will not have their intended effect.

During that time Keynes’s theories were decreasingly influential among economists. One of the mainstream schools among economists today is known as new classical economics, which applies rational expectations theory to all aspects of the economy.