Rational Expectations : Meaning, Nature and Everything Else

Read this article to learn about the meaning, nature, definitions and origin of concept of rational expectations in economic theory.

Meaning:

Rational Expectation is the focal point of the modern debate in Economic Theory. It is a surprisingly simple concept but its implications are radical and profound.

The rational expectations revolution highlighted some of the shortcomings of the orthodox ‘Keynesian Synthesis’—which governed economic policy during the 1950s and 1960s.

It claims to have provided a better alternative theory to guide policy during the 1980s onwards. The failure of pre-existing-theory to explain the dismal economic performance during the 1970s and 1980s of the economies practically all over the world, gave rise to the theory of ‘Rational Expectations’—called the theory of ‘Ratex’.

A general idea had developed during the long boom of (1950-70) that the government policy based on macroeconomic theory could be used to avoid depression. Yet developed economies were plagued with high inflation and high unemployment. This phenomenon of ‘stagflation’ during 1970s through the 1980s posed a serious challenge and out of this crisis a new variant of macroeconomic theories emerged—called rational expectations! Whereas, the economists once debated whether fiscal policy was more effective than monetary policy as a tool of macroeconomic management? They now argue whether the macroeconomics can be managed at all? This kind of pessimism seems to have arisen due to two inter-related phenomena—the persistent high levels of inflation and unemployment in many countries of the world and the rise of a new set of theoretical propositions in economics; loosely termed as ‘rational expectations macro theory’.

Apparently, this variant of macroeconomic theories was very appealing, because it explained how high level of inflation and unemployment could co-exist without providing any possibility of an active policy of demand management. Its emphasis is that the government could do no good but plenty of harm, so it was best that they are not involved in the functioning of the economies, but a theory has emerged to tell us (perhaps convincingly) that there is little that we (economists) can do about it (by demand management).

Expectations are important for three principal reasons:

(i) Expectations have to do a lot with the views about future values of economic variables like— price, output, employment and others;

(ii) These views exert a strong influence upon what happened today. For example, our expectations about the future inflation rate will undoubtedly influence current buying decisions;

(iii) Expectations have a crucial relationship between one of the fundamental ideas employed in economic analysis, namely, the concept of equilibrium.

All schedules used in economic analysis represent ex-ante or expected or anticipated values of the variable concerned. It is true that at both the micro and macro levels of economic analysis. What equilibrium, therefore, means is a state or conditions in which actual ex-post and expected values coincide. In other words, in equilibrium condition events turn out as people expect them to be.

Nature and Scope:

Broadly speaking, there are two main competing views in contemporary economics—the ‘activists’ and the ‘passivists’. The ‘activists’ believe that the economics do not attain stable equilibrium position employing the resources of the society at an optimum level. The ‘activities’ are so called because they believe that government can manage the economy and should intervene to stabilize it to ensure that there is no unutilized labour and capital at the general level of equilibrium. This management or intervention is done through monetary and/or fiscal policy.

The passivists, on the other hand feel convinced that the economies will achieve desirable equilibrium levels without any intervention or management and that the government actions are neither relevant nor necessary, in fact, there are positively harmful! During the 1960s, the image of the governments was that they could ‘fine-tune’ the economy and could manage and control and direct the economy towards the attainment of desirable objectives of income and employment. The governments of the period were guided in their behaviour by the macro-theory given by and modified after Keynes and by their faith that this theory was appropriate to achieve the social objectives.

However, everything changed with the advent of ‘stagflation’ in the early 1970s—when the growth rates declined sharply and inflation and unemployment rates increased. The growth rate of the real GDP at market prices declined from 6 per cent in 1965 to – 0.2 per cent in 1980s in USA; from 5.6 to 1.8 per cent in Germany, from 2.3 per cent to -1.8 per cent in UK, from 6.8 per cent to 0.1 per cent in Canada and from 5.7 per cent to 2.9 per cent in Australia.

Similarly, unemployment rate as per cent of total labour force rose from 4.4 per cent in 1965 to 7.0 per cent in 1980 in USA, from 0. 3.per cent to 3.1 per cent in Germany, from 2.3 per cent to 7.4 per cent in UK, from 3.6 per cent to 7.5 per cent in Canada, from 1.5 per cent to 6 per cent in Australia. Again, the rate of inflation increased from 1.7 per cent in 1965 to 13.5 per cent in 1980 in USA; from 3.4 per cent to 5.5 per cent in Germany, from 4.8 per cent to 18 per cent in UK from 2.4 per cent to 10.1 per cent in Canada and from 4 per cent to 10.2 per cent in Australia.

None of these countries was able to find a macroeconomic policy which the government could follow or implement and which could also eliminate unemployment and inflation. Thus, from the ‘super-potent’ position which the governments enjoyed—they were reduced to almost ‘impotent’ position where the government’s fiscal and monetary policies utterly failed to achieve anything much less to control unemployment and inflation. The theoretical challenge to the existing faith in the power of the government to manage the economy was led by passivists—adding a new twist to their argument.

The passivists while opposing the activists orthodoxy of the 1960s, also insisted that the phenomenon of ‘stagflation’ had been caused by activists policy. Led by the rational expectations theorists they argued that the government had no power to change the level of unemployment by demand side policies and that if they still persisted in following demand management policies, inflation would result. The rational expectionists also gave attention to the role of the government but on its ‘impotence’ rather than on its ability to do any good by managing the economy.

All this led to the sudden fall of Keynesian macroeconomics from the grace it once enjoyed. Rational expectations theories which focused upon the supply rather than demand side of economics fulfilled this role. Such theories suggested that there was little the government could do about inflation and unemployment. As a result of this and without effective demand side tools governments were forced to rely on giving incentives to investors to expand supply with the argument that as the benefits of expansion ‘trickle down’ to the rest of the economy the growth will take place.

Definitions:

The basic assumption about individual behaviour is that economic agents do the best they can with what they have. It forms the basis of consumption, production and human capital theory and so on. Now this very principle applies to the formation of expectations. Rational expectation is the application of the principle of rational behaviour to the acquisition and processing of information and to the formation of expectations.

In other words, if economic agents are rational maximizes, it is consistent to consider “information gathering’ and ‘expectation formation’ as determined by the same procedure. Rational expectations approach implies that expectations are formed on the basis of all currently available information. What ‘Ratex’ Theory typically states is that for some period of time, called period I, information is incomplete so that expectations, although unbiased and rational, given the information available are nevertheless bound to prove incorrect in retrospect. It is for this period of time that central banks can ‘deceive’ labour by creating money and raising prices without raising wages.

Thus, real wages fall and employment is encouraged. But these employment gains disappear in ‘period 2′ when full information about monetary policy and rising prices is available, and rational expectations become correct (except, of course, for random errors). The point is that the length of time to pass from period 1 to period 2 is implied to be very short perhaps a few months at the most just the period of time it takes to release money supply statistics. Phillips’ curve suggests that wage inflation will not come down as quickly as price inflation, and that this causes unemployment to rise above its ‘natural’ rate.

However, unemployment will fall back to its natural rate as soon as labour’s price expectations adjust downward so as to accord with the new and permanently lower inflation rate. Rational expectations theory makes the further suggestion that expectations will become ‘correct’ in this sense as soon as all relevant information becomes available, that is, in simple cases, as soon as money supply statistics have been released.

Rational Expectations are explicit predictions (forecasts) about the level or rate of change of some economic variables based on the use of the best model and all the information available thereof. In other words, these are rational economic predictions based on economic model. What the rational expectations theorists have done differently (from Keynes etc.) is to demonstrate to economists a new way of dealing with expectations in their model and attempting how these expectations are formed. Keynes did give importance to expectations but did not mention how these expectations are formed?

Expectations (in economics) are essentially forecasts of the future values of economic variables which are relevant to current decisions. For example, firms have to forecast future prices for ‘their products to decide how much to produce in the current period and whether or not to invest in the new equipment. Similarly, labour unions have to predict the future rate of inflation in their wage bargaining.

Again, farmers have to forecast future prices for various crops in order to determine the crops which are most profitable to produce. Expectations, then are the decision-makers forecasts or predictions regarding the uncertain economic variables which are relevant to his or her decision. Expectations are essentially subjective—the personal judgements of a particular individual. They do not have any independent existence apart from the person or the decision-makers who holds them. Again, expectations regarding a particular economic variable need not be confined to a single predicted value. It is often summarised by the mean of future values of the variables.

Origin of Concept:

Expectations as a concept seem to be growing increasingly important and much of economic theory is now being rewritten to take explicit account of them. However, this awareness of the importance of expectations is not a new phenomenon. Marshall (1920), for example, was aware of the importance of the concept, although as Shackle (1967) comments this was not a trumpet he chose to blow too hard.

But it was really in Sweden that the importance of expectations in economic theory was first fully appreciated, with the work of Myrdal (1939) amongst others, while in England at about this time Keynes’ General Theory had just appeared, in which expectations are of prime importance.

In recent times, however, the concept of rational expectations was first put forward by Muth (1961), who was, in turn, building upon ideas originally put forward by Modigliani and Grunberg (1954). Muth proposed that certain expectations were rational, in the sense that they were essentially the same as the predictions of the relevant and correct economic theory, thus implying that expectations and the events differ only by a random forecast error.

This was originally proposed within the context of the decision-making process of the firm, where it remained relatively unnoticed until picked up by Lucas (1972) and Sargent (1973), who translated it into the field of macroeconomics in general and inflation in particular. In this case of ‘Ratex’ expected inflation can differ from actual inflation by random forecast error.

The whole concept of ‘Ratex’ has been the subject of much discussion, with a great volume of literature growing up in a remarkably short space of time. Indeed it is no exaggeration to say that this probably represents the most important theoretical innovation in macroeconomics in the last decade. Besides, the original contributions by Lucas and Sargent, important contributions have also been made, for example, by Sargent and Wallace (1973, 1975, 1976), Barro (1976, 1977) and McCallum (1976) to the development of the theory of Rational Expectations called ‘Ratex’.

Keynes on Expectations:

Expectations play an important role in Keynes General Theory. His analysis of the level of unemployment, demand for money, the level of investment and trade cycles all depend upon the crucial role of expectations while discussing the determination of the level of employment, Keynes wrote, “Thus, the behaviour of each individual firm in deciding its daily output will be determined by its short-term expectations as to the cost of output on the various possible scales and expectations to the sale-proceeds of this output……………” It is upon these various expectations that the amount of employment which the firms offer will depend. The actually realized results of production and sale of output will only be relevant to employment insofar as they cause a modification of subsequent expectations.

Most of this early work was connected with the effects of expectations, rather than with how they were formed? Keynes, at least, thought that some expectations were closely akin to a random variable and hence unexplainable, that is, unless a theory of animal spirits can be provided. Since then, and particularly since 1960, a substantial volume of literature has appeared concerning with how expectations are formed? This can be divided into two fairly distinct parts, that dealing with theoretical considerations, and that which is mainly empirical in nature.

There has, of course, been some interchange between these two avenues of research, but unfortunately this has not been common, and they have by and large remained separate areas. However, in spite of the leading role that Keynes gave to his expectations in his model, he did not really address the question of how expectations are formed? Again, his notion of expectations was a long way from an operational concept. A good deal of research work on macroeconomics in recent times can be seen as an attempt to alter the Keynesian expectations based theory into an operational theory with testable hypotheses.