Rational Expectations Theory

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Rational Expectations Theory

In economics, a theory stating that economic actors make decisions based on their expectations for the future, which are based on their observations and past experiences. A basic example of rational expectations theory is a situation in which a consumer delays buying a certain good because, based on his/her observations and experiences, he/she believes that the price will be less expensive in a month. If enough consumers believe that, demand eases and the good is likely to actually be less expensive next month. Thus, the consumer waits a month before buying the good. Rational expectations theory states that current expectations strongly influence future performance. Economists disagree about how well the rational expectations theory works in the real world.
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This is inconsistent with the rational expectations hypothesis, and points to more realistic economic models of expectation formation and actual behavior.
Our results suggest that the rational expectations hypothesis is not fulfilled, but that the "weak form of rationality" is verified in any time horizon.
However, and importantly, the rational expectations hypothesis does not speak to how agents come to have their pessimistic or optimistic beliefs: there is no selection mechanism associated to the theory.
Sargent using application of the rational expectations hypothesis came to the conclusion that a coordinated monetary policy has no effect on the elimination of unemployment and production increase.
The rational expectations hypothesis (REH) is a theoretically attractive framework for assessing the mechanism with which economic agents process information when formulating judgments about the real world (Krause 2000).
The test was initially conceived to test the rational expectations hypothesis in macroeconomics, to supply a statistical comparison between a measure of pricing by the market (valuation coefficient) and another of rational expectations (forecasting coefficient) given by a relevant variable.
(11) So, this answer to the rational expectations critique only applies if rational expectations are rare--a claim that the rational expectations hypothesis denies.
First, if the rational expectations hypothesis holds continuously (i.e., Equation 3), the rejection of the FRUC could be due to the presence of a risk premium.
Perhaps most significant, however, was the challenge that emerged from advocates of the New Classical School, who refined their assumptions about human behavior, economic relationships, and market processes and laid three foundation stones for analysis: market participants possess all relevant information about current events and possible future developments and act in automaton-like fashion to maximize utility (rational expectations hypothesis); variations in economic output are attributable solely to disturbances on the supply side of the economy that impact productivity (real business cycle theory); and current prices in financial markets adequately and appropriately reflect the tradeoff between risk and return (efficient financial market theory).
Another important theme of the book is that traditional methods of economic inquiry, such as the efficient market hypothesis and the rational expectations hypothesis, are not well suited for analyzing financial bubbles.