Rational Expectations

Published Jan 14, 2023

Definition of Rational Expectations

Rational expectations is an economic theory that states that people’s expectations about the future are based on their past experiences and all the available information they have. That means people form their predictions about the future by using the best available information and their own knowledge and experience.

Example

To illustrate this, let’s look at the stock market. According to the concept of rational expectations, investors make decisions about which stocks to buy or sell based on their past experiences and all the available information they have, like balance sheets, news reports, and so on. If a company has been performing well in the past and the available information suggests that it will continue to do so in the future, investors will be more likely to buy its stock. On the other hand, if the company has been performing poorly and the available information suggests that it will continue to do so, investors will be more likely to sell its stock. That way, they will still end up being wrong sometimes, but on average, they will be correct more often than not.

Why Rational Expectations Matters

The theory of rational expectations is important for policymakers because it provides a framework for understanding how people form their expectations about the future. This is especially relevant for macroeconomic policies, such as monetary and fiscal policies. If the government increases taxes, people will expect their incomes to decrease and will adjust their spending accordingly. This, in turn, can have a significant impact on the economy.