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Rational Expectations Theory Definition and How It Works

What is rational expectations theory.

The rational expectations theory is a concept and modeling technique that is used widely in macroeconomics . The theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences.

The theory suggests that people’s current expectations of the economy are, themselves, able to influence what the future state of the economy will become. This precept contrasts with the idea that government policy influences financial and economic decisions.

Key Takeaways

  • The rational expectations theory posits that individuals base their decisions on human rationality, information available to them, and their past experiences.
  • The rational expectations theory is a concept and theory used in macroeconomics.
  • Economists use the rational expectations theory to explain anticipated economic factors, such as inflation rates and interest rates.
  • The idea behind the rational expectations theory is that past outcomes influence future outcomes.
  • The theory also believes that because people make decisions based on the available information at hand combined with their past experiences, most of the time their decisions will be correct.

Understanding Rational Expectations Theory

The rational expectations theory is the dominant assumption model used in business cycles and finance as a cornerstone of the efficient market hypothesis (EMH) . 

Economists often use the doctrine of rational expectations to explain anticipated inflation rates or any other economic state. For example, if past inflation rates were higher than expected, then people might consider this, along with other indicators, to mean that future inflation also might exceed expectations.

Using the idea of “expectations” in economic theory is not new. In the 1930s, the famous British economist, John Maynard Keynes assigned people’s expectations about the future—which he called “waves of optimism and pessimism”—a central role in determining the business cycle.

However, the actual theory of rational expectations was proposed by John F. Muth in his seminal paper, “Rational Expectations and the Theory of Price Movements,” published in 1961 in the journal, Econometrica . Muth used the term to describe numerous scenarios in which an outcome depends partly on what people expect will happen. The theory did not catch on until the 1970s with Robert E. Lucas, Jr . and the neoclassical revolution in economics.

The Influence of Expectations and Outcomes

Expectations and outcomes influence each other . There is continual feedback flow from past outcomes to current expectations. In recurrent situations, the way the future unfolds from the past tends to be stable, and people adjust their forecasts to conform to this stable pattern.

This doctrine is motivated by the thinking that led Abraham Lincoln to assert, “You can fool some of the people all of the time and all of the people some of the time, but you cannot fool all of the people all of the time.”

From the perspective of rational expectations theory, Lincoln’s statement is on target: The theory does not deny that people often make forecasting errors , but it does suggest that errors will not recur persistently.

Because people make decisions based on the available information at hand combined with their past experiences, most of the time their decisions will be correct. If their decisions are correct, then the same expectations for the future will occur. If their decision was incorrect, then they will adjust their behavior based on past mistakes.

Rational Expectations Theory: Does It Work?

Economics relies heavily on models and theories, many of which are interrelated. For example, rational expectations have a critical relationship with another fundamental idea in economics: the concept of equilibrium . The validity of economic theories—do they work as they should in predicting future states?—is always arguable. An example of this is the ongoing debate about existing models’ failure to predict or untangle the causes of the 2007–2008 financial crisis.

Because myriad factors are involved in economic models, it is never a simple question of working or not working. Models are subjective approximations of reality that are designed to explain observed phenomena. A model’s predictions must be tempered by the randomness of the underlying data it seeks to explain, and the theories that drive its equations. 

When the Federal Reserve decided to use a quantitative easing program to help the economy through the 2008 financial crisis, it unwittingly set unattainable expectations for the country. The program reduced interest rates for more than seven years. Thus, true to theory, people began to believe that interest rates would remain low.

The Library of Economics and Liberty. " Rational Expectations ."

Board of Governors of the Federal Reserve System. " The Crisis and the Policy Response ."

Federal Reserve Bank of St. Louis, FRED. " Federal Funds Effective Rate ."

critically examine rational expectation hypothesis

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critically examine rational expectation hypothesis

  • > Individual Forecasting and Aggregate Outcomes
  • > Keynesianism, monetarism, and rational expectations: some reflections and conjectures

critically examine rational expectation hypothesis

Book contents

  • Frontmatter
  • List of contributors
  • 1 Introduction
  • 2 The trouble with “rational expectations” and the problem of inflation stabilization
  • 3 Expectations of others' expectations and the transitional nonneutrality of fully believed systematic monetary policy
  • 4 The stability of rational expectations in macroeconomic models
  • 5 Individual rationality, decentralization, and the rational expectations hypothesis
  • 6 Convergence to rational expectations equilibrium
  • 7 A distinction between the unconditional expectational equilibrium and the rational expectations equilibrium
  • 8 On mistaken beliefs and resultant equilibria
  • 9 Equilibrium theory with learning and disparate expectations: some issues and methods
  • 10 Keynesianism, monetarism, and rational expectations: some reflections and conjectures

10 - Keynesianism, monetarism, and rational expectations: some reflections and conjectures

Published online by Cambridge University Press:  05 June 2012

To what extent is Keynesianism discredited? Is there anything left? Did Monetarism score a total victory? Must Rational Expectations make New Classical economists of us all? Every teacher of macroeconomics has to wrestle with these questions – hoping against hope that some new cataclysm will not let some fantastic supply-side doctrine or whatever sweep the field before he has been able to sort through the rubble of what once he knew. I am going to sort some of my rubble. The object of the exercise is to make some guesses at how the seemingly still usable pieces might fit together.

My starting points are as follows. Keynesianism foundered on the Phillips curve or, more generally, on the failure to incorporate inflation rate expectations in the model. The inflation, which revealed this critical fault for all to see, was in considerable measure the product of “playing the Phillips curve” policies. But the stable Phillips trade-off was not an integral part of Keynesian theory. Its removal, therefore, should not be (rationally) expected to demolish the whole structure.

Monetarism made enormous headway in the economics profession and with the public when the misbehavior of the Phillips curve and the inflation premium in nominal interest, rates became obvious for all to see. And few observers could continue to doubt the strong link between nominal income and money stock as the Great American Inflation went on and on and on.

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  • Keynesianism, monetarism, and rational expectations: some reflections and conjectures
  • By Axel Leijonhufvud , Frank Hahn
  • Edited by Roman Frydman , Edmund S. Phelps
  • Book: Individual Forecasting and Aggregate Outcomes
  • Online publication: 05 June 2012
  • Chapter DOI: https://doi.org/10.1017/CBO9780511625763.011

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critically examine rational expectation hypothesis

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book: Rational Expectations and Inflation

Rational Expectations and Inflation

Third edition.

  • Thomas J. Sargent
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  • Language: English
  • Publisher: Princeton University Press
  • Copyright year: 2013
  • Edition: Third
  • Audience: Professional and scholarly;College/higher education;
  • Main content: 392
  • Keywords: Inflation ; Tax ; Government debt ; Macroeconomics ; Government budget balance ; Debt ; Fiscal policy ; Currency ; Rational expectations ; Price level ; Present value ; Monetary authority ; Monetary policy ; Monetarism ; Central bank ; Real versus nominal value (economics) ; Interest rate ; Government budget ; Milton Friedman ; Supply (economics) ; Depreciation ; Creditor ; Economic policy ; Payment ; Investment ; Expenditure ; Inflation tax ; Tax rate ; Economic surplus ; Interest ; Exchange rate ; Budget ; Value (economics) ; Seigniorage ; Government bond ; Hyperinflation ; Budget constraint ; Finance ; Banknote ; Hong Kong dollar ; Central government ; Fiat money ; S.A. (corporation) ; Tariff ; Economist ; Tax revenue ; Bond (finance) ; The New York Times ; Newsletter ; Liability (financial accounting) ; Economics ; Demand curve ; Economy ; National debt of the United States ; Balanced budget ; Unemployment ; Real interest rate ; Public expenditure ; Taxpayer ; The Wall Street Journal ; Par value ; Assignat ; Reaganomics ; Keynesian economics ; Indexation ; Policy ; Asset ; Tight Monetary Policy ; Nominal interest rate ; Arithmetic
  • Published: May 5, 2013
  • ISBN: 9781400847648
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Rational Expectations and Inflation (3rd edn)

Rational Expectations and Inflation (3rd edn)

  • Cite Icon Cite

This collection of essays uses the lens of rational expectations theory to examine how governments anticipate and plan for inflation, and provides insight into the pioneering research for which the author was awarded the 2011 Nobel Prize in economics. Rational expectations theory is based on the simple premise that people will use all the information available to them in making economic decisions, yet applying the theory to macroeconomics and econometrics is technically demanding. This book engages with practical problems in economics in a less formal, noneconometric way, demonstrating how rational expectations can satisfactorily interpret a range of historical and contemporary events. It focuses on periods of actual or threatened depreciation in the value of a nation's currency. Drawing on historical attempts to counter inflation, from the French Revolution and the aftermath of World War I to the economic policies of Margaret Thatcher and Ronald Reagan, the book finds that there is no purely monetary cure for inflation; rather, monetary and fiscal policies must be coordinated. This fully expanded edition includes the author's 2011 Nobel lecture, “United States Then, Europe Now.” It also features new articles on the macroeconomics of the French Revolution and government budget deficits.

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Rational Expectations and Inflation - Thomas J. Sargent (Third Edition)

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Rational expectations theory is based on the simple premise that people will use all the information available to them in making economic decisions, yet applying the theory to macroeconomics and econometrics is technically demanding.

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The Rational Expectations Hypothesis was first developed as a theoretical technique aimed at explaining agents’ behavior in a given environment. In particular, it describes how the outcome of a given economic phenomenon depends to a certain degree on what agents expect to happen. Subsequently, it was introduced into macroeconomic models as a way to explain the ineffectiveness of monetary policy. Since then, most of these models have been based on the rational expectations assumption. This paper assesses the real life application of this feature based on two arguments: the determination of an objective reality through beliefs and subjective expectations; and the exclusion of the evolution of human knowledge and innovation in macroeconomic models.

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In economic models, expectations about future parameters influence the behaviour of the agents. To have a well-defined model one has to write down a closed system of equations that relates expected and real values. Infinite rationality with perfect foresight provides a simple and appealing recipe. Other possibilities include adaptive expectations and/or evolving, adaptive agents. In this paper we examine critically some of these ideas in a simple model for inflation.

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The transcript of a panel discussion marking the 50th anniversary of John Muth's “Rational Expectations and the Theory of Price Movements” (Econometrica 1961). The panel consisted of Michael Lovell, Robert Lucas, Dale Mortensen, Robert Shiller, and Neil Wallace. The discussion was moderated by Kevin Hoover and Warren Young. The panel touched on a wide variety of issues related to the rational-expectations hypothesis, including its history, starting with Muth's work at Carnegie Tech; its methodological role; applications to policy; its relationship to behavioral economics; its role in the recent financial crisis; and its likely future.The panel discussion was held in a session sponsored by the History of Economics Society at the Allied Social Sciences Association (ASSA) meetings in the Capitol 1 Room of the Hyatt Regency Hotel in Denver, Colorado.

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Theory of Rational Expectation | Theories| Macroeconomics

critically examine rational expectation hypothesis

The new classical macroeconomics is based on the rational expectations hypothesis. This means that people have rational expectations about economic variables. The implication is that people make intelligent use of available information in forecasting variables that affect their economic decisions.

According to this hypothesis, forecasts are unbiased and based on all available information. The hypothesis holds that people make unbiased forecasts. A more controversial assumption is that people use all available information and economic theory in making decisions.

This im­plies that people understand how the economy works and how the government policies alter macroeconomic variables such as the price level, the level of employment and aggregate out­put. And because of rational expectations, the government cannot fool the people with system­atic economic policies.

The idea of rational expectations was first discussed by John F. Muth in 1961. However, the idea was not widely used in macroeconomics until the new classical revolution of the early 1970s, popularized by Robert Lucas and T. Sergeant. No doubt, the theory of rational expectations is a major breakthrough in macroeconomics.

ADVERTISEMENTS:

Until the early 1970s, macroeconomists thought of expectations in one of two ways:

1. Animal Spirits:

The term ‘animal spirits’ was coined by J .M .Keynes to refer to move­ments in investment that could not be explained by movements in current variables. In other words, shifts in expectations were considered important but unexplained.

2. Adaptive Expectations:

The second one was the result of simple, backward-looking rules. For example, people were often assumed to have static expectations, that is, to expect the future to be like the present. This assumption is used while discussing the Phillips curve and explaining investment decisions. In other words, people were assumed to have adaptive expec­tations.

If, for example, their forecast of a given variable in a given period turned out to be too low, people were assumed to “adapt” by raising their expectation for the value of the variable for the next period. For example, seeing an inflation rate higher than they had expected, led people to revise upward their forecast of future inflation upward.

In the early 1970s, Robert Lucas and Thomas Sergeant argued that their assumptions did not reflect the way people form expectations. They argued that in thinking about the effect of alternative policies, economists should assume that people have rational expectations, that people look into the future and try to predict the future as best (accurately) as they can. This is not the same as assuming that people know the future, but rather that they use the information they have, in the best possible way.

Practical Implications: Policy Ineffectiveness :

One of the most important contentions of rational expectations is the ineffectiveness of system­atic fiscal and monetary policies in reducing unemployment. The basic idea is that a predict­able attempt to stimulate the economy would be known in advance, and would have no effect on the economy. This is known as the policy ineffectiveness theorem. With rational expectations and flexible prices and wages, anticipated government policy cannot affect real output or employment.

Lucas and Sergeant showed how replacing traditional assumptions about the formation of expectations, by the assumption of rational expectations, could fundamentally alter the results. In particular, Lucas challenged the notion that disinflation necessarily required an increase in unemployment for some time. This is known as the Lucas critique.

Lucas pointed out that when trying to predict the effects of a major policy change—like the change considered by the central bank at the time—it could be very misleading to take as given the relations estimated from past data.

Lucas argued that, if wage setters believed that the central bank was committed to lower inflation, they might well expect inflation to be lower in the future than in the past. If they lowered their expectations of inflation, then actual inflation would decline without the need for a protracted recession.

The logic of Lucas’s argument can be explained briefly. If wage setters kept forming expec­tations of inflation (π e ) by looking at the last year’s inflation (π e ), i.e., π e = π t-1 then the only way to decrease inflation would be to accept high unemployment for some time.

But, if wage setters could be convinced that inflation was indeed going to be lower than in the past, they would decrease their expectations of inflation. This would, in turn, reduce actual inflation, without any change in the rate of unemployment.

For example, if wage setters were convinced that inflation, which had been running at 10% in the past, would be only 3% in the future, and if they formed their expectations accordingly, then inflation would fall to 3%, even if the actual rate of unemployment was the same as its natural rate.

Nominal money growth, inflation, and expected inflation could all be reduced even in the absence of a recession. Alternatively stated, decreases in nominal money growth could be neu­tral not only in the medium term, but also in the short run.

Lucas and Sergeant did not believe that disinflation could really be achieved without toler­ating more unemployment. But Sergeant argued that increase in unemployment could be small. The sacrifice ratio—the amount of excess unemployment needed to achieve disinflation— might not be much lower than that suggested by the traditional approach.

Credibility of Policy :

The essential ingredient of successful disinflation is credibility of monetary policy—the belief by wage setters that the central bank is truly committed to reducing inflation. The credibility view is that, fast disinflation is likely to be more credible than slow disinflation. Credibility decreases the unpleasant cost of disinflation. So it is judicious for the central bank to go for fast disinflation.

Only credibility would cause wage setters to change the ways they formed their expectations. In addition, a clear and quick disinflation programme was much more likely to be credible than a protracted one that offered plenty of opportunities for reversal.

Implications :

The rational expectations assumption has important implications. For example, if monetary non-neutrality is due to temporary misperceptions of the price level and people have rational expectations about prices, monetary policy does not affect the real economy systematically.

According to Lucas, the central bank cannot systematically surprise the public if the public has rational expectations. Lucas’s basic point is that public’s forecasts of various economic variables, including money supply, the price level and, the GDP are based on reasoned and intelligent examination of available economic data.

If people have rational expectations they will eventually understand the central bank’s general pattern of behaviour. If expectations are rational, purely random changes in the money supply may be unanticipated and non-neutral However, because the central bank would not be able to surprise the public systematically it cannot use monetary policy to stabilise output. Thus, even if control of business cycles were desirable, according to rational expectations, the central bank cannot use monetary policy to do so.

Monetarist Rules and the Lucas Critique :

The rational expectations hypothesis has challenged the key assumption of the monetarist school, namely, stability (constancy) of the velocity of money. The monetarists believe that it is possi­ble to stabilise MV= PY, nominal GDP, by imposing a fixed-money rule.

But Lucas argues that people may change their behaviour when policy changes. The appar­ently constant velocity may change if the central bank adopts a fixed-money growth rule. Lucas’s argument is a stern warning to monetarists that economic behaviour can change when policy­makers rely too heavily upon past regularities.

A Complete Rethinking :

In a more general sense, Lucas and Sergeant’s research showed the need for a complete re­thinking of macroeconomic models under the assumption of rational expectations. And this is exactly what had happened over the next two decades.

A Challenge to the Phillips Curve Hypothesis :

In a sense, the rational expectations hypothesis threw a challenge to the Phillips curve hypothesis on the short-run trade-off between inflation and unemployment. If economic agents simply adapt their behaviour to the difference between expected and realised events, they will be constantly disappointed during periods of rising inflation.

So they are instead conceived as forming their expectations on the basis of exactly the same information that is available to policymakers. An expansionary fiscal policy or an easy monetary policy, designed to reduce unemployment, is correctly perceived to lead to higher prices; in consequence, private spending accelerates.

As a consequence, there is instant inflation without much effect on real variables such as GDP and employment. This is a refutation of the Phillips curve conjecture that there is a trade-off between inflation and unemployment even in the short run.

The only way a government can bring about deviations from the ‘natural rate of unemployment’ is by surprising people. But if people learn from experience, this will only work once or twice; sooner or later people will learn correctly to anticipate any systematic government policy and, at that point, unemployment will never deviate, except momentarily, from its natural rate.

Theory and Practice :

Most macroeconomists today use rational expectations as a working assumption in their mod­els and analysis of policy. When thinking about the likely effects of a particular economic policy, the best assumption to make seems to be that people and firms will do the best they can to work out its implications. Designing a policy on the assumption that people will make sys­tematic mistakes in responding to it is unwise.

Under rational expectations, what happens today depends on expectations of what will hap­pen in the future. But what happens in the future also depends on what happens today. The success of Lucas and Sergeant in convincing most macroeconomists to use rational expecta­tions comes not only from the strength of their argument, but also from showing how it could actually be done.

An Application of the Re-Hypothesis: Accuracy of Inflation Forecasts :

The rational expectations approach has been used by economists to test the accuracy of infla­tion forecasts. Suppose P e t is an individual’s forecast, made in year t – 1 of the price level in year t. Suppose also the actual price level in year; be P t . Then the difference between the actual price level and the individual’s forecast measures his forecast error for year t. P t – P e t = r t = the individual’s forecast error in year t.

If people have rational expectations, these forecast errors are due to exogenous factors, i.e., unpredictable random numbers. However, if errors are con­sistently positive or negative implying that people systematically tend to under predict or over predict the price level expectations are not rational. If forecasts follow a systematic pat­tern for example, if people tend to over predict the price level when prices have been rising in the recent past again, expectations are not rational.

Conclusion :

Much progress has been made in the last three decades in developing solution methods for larger and larger models. Today, a number of macroeconomic models are solved under the assumption of rational expectations.

In the ultimate analysis, it appears that the rational expectations assumption is attractive to economists including many new-Keynesian and new-classical economists because it fits well economists’ presumption that people systematically, logically and intelligently pursue their economic self-interests. If people’s expectations are not rational, the economic plans that individuals make would not be generally as good as they could be.

However, the theoretical effectiveness of rational expectations obviously is not enough. Economists would like to know whether people really do have rational expectations about important economic variables such as the money supply growth, the price level and stock prices.

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  1. Rationalizing rational expectations: Characterizations and tests

    1 Introduction. How individuals form their beliefs about uncertain future outcomes is critical to understanding decision making. Despite longstanding critiques (see, among many others, Pesaran (), Manski ()), rational expectations remain by far the most popular framework to describe belief formation (Muth ()).This theory states that agents have expectations that do not systematically differ ...

  2. The Rational Expectations Hypothesis: Theoretical Critique

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  3. PDF Introductory Notes on Rational Expectations 1 Overview

    It is critically important to observe that the de nition given above for a weak-form rational. ectively-true probability assessments for the possible2See the appendix at the end of these notes for a discussion of the distinction between conditional and unconditional expectations, and for a more careful.

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    Rational expectations is an economic theory that seeks to infer the macroeconomic consequences of individuals' decisions based on all available knowledge. It assumes that individuals actions are based on the best available economic theory and information, and concludes that government policies cannot succeed by assuming widespread systematic ...

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    The third key tenet is the Rational Expectations Hypothesis (REH). This very bold assumption arose as a reaction against the pitfalls of the other expectational hypotheses. It is made not because of its realism, but because of its obvious theoretical appeal.

  6. PDF The Rational Expectations Hypothesis: Theoretical Critique

    The rational expectations hypothesis was further developed in macroeconomic theory by Lucas (1972, 1976) and Sargent and Wallace (1975) and has been broadly accepted. The rational expectations ...

  7. Rational Expectations Theory Definition and How It Works

    Rational Expectations Theory: The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences. The ...

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    Rational expectations is an economic theory that suggests individuals make predictions about the future based on all available information, including past events and current market conditions. This theory assumes that people are forward-looking and make decisions based on rational analysis, leading to more accurate predictions and efficient ...

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  10. Rational Expectations and Inflation

    A fully expanded edition of the Nobel Prize-winning economist's classic book This collection of essays uses the lens of rational expectations theory to examine how governments anticipate and plan for inflation, and provides insight into the pioneering research for which Thomas Sargent was awarded the 2011 Nobel Prize in economics. Rational expectations theory is based on the simple premise ...

  11. Keynes, Harrod, and the Rational Expectations Revolution

    analyzes how rational expectation techniques affect the structure and results of a dynamic Keynesian output determination model based on Harrod's (1939) growth theory. I show that standard rational expecta-tions arguments do not stabilize the model. In fact, some of the consid-erations suggested by the rational expectations approach make the

  12. PDF The Rational Expectations Revolution An Assessment

    Muth's rational expectations hypothesis br the Phillips curve and the analysis of labormarkets. Lucas's ([1972a] 1981) article, "Econo-metric Testing of the Natural Hate Ilypothesis," will serve as the paradigm. 8 The article accomplished three things critical to the development ofnew classical macroeconomics.

  13. (PDF) Adaptive and Rational Expectations Hypotheses: Reviewing the

    The rational expectations hypothesis does not argue that the random variable will always have a value of zero - that is, there is not always perfect foresight (Lane, n.d.; see Levine,

  14. PDF A New Rational Expectations Hypothesis

    1 Overview. John Muth proposed the Rational Expectations Hypothesis (REH) to represent how the market (an aggregate of its participants) understands and forecasts outcomes. REH imposes internal consistency between the market's forecasts and "the relevant economic theory" (Muth 1961, p. 316). In implementing REH, economists have relied on ...

  15. (PDF) Adaptive and Rational Expectations Hypotheses: Reviewing the

    The Rational Expectations Hypothesis was first developed as a theoretical technique aimed at explaining agents' behavior in a given environment. In particular, it describes how the outcome of a given economic phenomenon depends to a certain degree on what agents expect to happen. Subsequently, it was introduced into macroeconomic models as a ...

  16. Rational Expectations and Inflation (3rd edn)

    Abstract. This collection of essays uses the lens of rational expectations theory to examine how governments anticipate and plan for inflation, and provides insight into the pioneering research for which the author was awarded the 2011 Nobel Prize in economics. Rational expectations theory is based on the simple premise that people will use all ...

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    The rational expectation hypothesis ... of subjects' predictions in order to analyse whether there was a convergence to the fundamental value and to examine the volatility of the process. ... The random difference equation X n = A n X n − 1 + B n in the critical case. The Annals of Probability, 25 (1) (1997), pp. 478-493.

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    A rational expectation of real wage will take into account all available information, including the effects of government policy. But the critics argue it is alright that expectations should be based on all the available information including the future impact of government policy—but then how does this theory of rational expectations leads to the conclusion or proves that government policy ...

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    Question: Critically examine the rational expectation hypothesis (10 M) Critically examine the rational expectation hypothesis (10 M) There's just one step to solve this. Step 1. Rational expectation theory is developed by American economist John Fraser Muth in 1930.Rational exp... View the full answer. Answer. Unlock.