Rational
Expectations
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
Adaptive Expectations
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The “natural rate” hypothesis of Phelps
and Friedman is based on agents
expectations of the future.
Only when expectations are not realized
is unemployment different than the
natural rate of unemployment.
During the time when expectations are
not realized, agents make systematic
errors in their decision-making.
Importance of Expectations
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Subjective expectations are
fundamental to behavior of agents in
all economic activities.
All actions are future-oriented.
Expectations in Economics
Keynes emphasis on uncertainty
 Shackle, Mises, Lachmann essays in
1930s concerning “elasticity of
expectations”
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Rational Expectations
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Tinbergen, “Ein Problem der Dynamik,”
Zeitschrift fur Nationalökonomie, (1932).
Walters, “Consistent Expectations,
Distributed Lags and the Quantity Theory,”
Economic Journal (June 1971).
Muth, “Rational Expectations and the Theory
of Price Movements,” Econometrica, (July
1961).
Lucas, “Expectations and the Neutrality of
Money,” Journal of Economic Theory (April
1972).
Rational Expectations
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Basic argument: Agents will be
forward-looking in their expectations,
not backward-looking. While there is
error-learning that does take place,
expectations are not “adaptive.”
Muth: “expectations, since they are
informed predictions of future events,
are essentially the same as the
predictions of the relevant economic
theory.”
Weak Version
In forming expectations about the
future value of a variable,
economic agents make the best
use of all publicly available
information about factors they
believe determine the variable.
Strong Version
Economic agents’ subjective
expectations of economic
variables will coincide with the
objective mathematical
conditional expectations of those
variables.
Xet = E (Xt | Ωt-1)
What Ratex Are and Aren’t
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Rational expectations are not the same
thing as perfect foresight
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Agents make errors due to incomplete
information
Rational expectations are correct on
average
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no systematic bias over time
What Ratex Are and Aren’t
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Strong version; Xet = Xt + єt
forecasting errors have mean = 0
 forecasting errors are serially
uncorrelated
 forecasting errors have lowest variance
relative to any other method
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Objections to Ratex
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Costs of acquiring and processing all
publicly available information
Whether agents can learn true model
of economy
The world is non-ergodic; each
historical event is unique and nonrepetitive. One cannot conceive of a
probability distribution of unique
events.
In defense of Ratex
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Does not require use of all information,
but best use (equate marginal benefits
and costs)
Does not require true model of
economy – only that agents
expectations are not systematically
wrong (“as if”)
All business cycles share similarities;
meaningful probability distributions
can be estimated
Incentives for Ratex
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Agents wealth at stake
Adaptive expectations are serially
correlated
Uses current rather than past
information
Evidence for Ratex
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Expectations in survey data are
influenced by age, geography,
education and other variables
Weak direct econometric support
Ergodicity and Institutions
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Davidson: Shackle’s crucial decisions
and non-ergodicity of events in
historical time
Leijonhufvud: Even if agents can form
expectations rationally, the results of
a monetary regime that is a “random
walk” prevents the implications that
are tied to Ratex from being realized