rational expectations theory

Investments should take careful consideration of a lot of factors. Sometimes, emotions get the best of them. Other times, they use rational and objective reasons for their investment decisions. To conclude the investment theory series, this article will discuss rational expectations.

What is the Rational Expectations Theory?

The rational expectations theory is an investment concept used widely in macroeconomics. The theory postulates that decisions made by individuals depend on three main factors:

  • Human rationality
  • Available information
  • Past experiences

It proposes that the current expectations of the economy can influence the outlook of the economy. This thinking negates the fact that government policies are the main drivers of economic and financial decisions.

Economic analysts use the theory of rational expectations to clarify projected inflation rates. For instance, people may expect higher than expected future inflation because past inflation rates were higher than what was expected. For this reason, the rational expectations theory is the presiding assumption model commonly applied in finance and business cycles. It is the cornerstone of the efficient market hypothesis.

People who believe in this theory assumes that the standard economic assumption that people will act in a way that would enable them to maximise their profits or utility. 

Does Rational Expectations Theory Work?

Interrelated models and theories guide economics to a great extent. Rational expectations are heavily interlinked with the concept of equilibrium. To answer the questions of the validity of economic theories is always open for argument. There is a slew of factors that economics must consider when using models. Models are merely subjective approximations of reality to explain perceived phenomena. These predictions must then be counterbalanced with random data. 

One concrete example of this was during the 2008 Financial Crisis. The Federal Reserve used a quantitative easing program to improve economic status. As a result, it caused impossible expectations since the program significantly implemented low-interest rates for the next seven years. Based on the theory, people expected the interest would stay low. 

What are the Differences Between Rational Expectations and Adaptive Expectations?

The key differences between the two theories include:

  • Adaptive expectations believe that people only have limited access to information. Thus, they change their expectations gradually. On the other hand, rational expectations believe that prices will change quickly once new economic information becomes available.
  • Adaptive expectations use real-time data and expect rapid changes. However, rational expectations depend on past information. 
  • Government agencies are poised to use rational expectations more since they have access to economic data, while the general public has limited access to this information that’s why they would likely use adaptive expectations. 

Final Thoughts

Some recent studies use rational expectations to explain the processes in which financial and fiscal authorities can keep or lose their reputation for policy management. It is important to note that expectations and outcome influence each other. Past findings will definitely have some impact on current expectations. Should there be recurring situations, recent trends can become stable. When this happens, people can adjust their expectations accordingly. 

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