Rational expectations theory and applications

¶ … Monetarism and Economic Theory by F.H. Hahn, focuses on the Rational Expectations theory and it's relation to the competitive equilibrium based on accuracy and bias. Further, it recognizes the main flaws in the rational expectation theory as it relates to aggregate behavior, rationing techniques, and its application to other fields.

Defining the Rational Expectations Theory

The monetarist rational expectations theory is the optimal forecast based on all available information. The theory is based on several assumptions, the first being that agents adapt quickly to market changes and alter their behavior accordingly to maintain an efficient market. Thus, it is assumed that each agent's forecasted outcomes do not differ systematically from the market equilibrium results. Further, it assumes that agents are systematically error-free when predicting an economic future, and deviations from perfect foresight are merely random outliers.

Price and Information as it relates to the Rational Expectations Theory

Expectations are said to be rational if they make use of all available information (e.g. The state of nature and value of exogenous variables).

If an item's price does not reflect all the information about it, then unexploited profit opportunities will result in buying or selling to make a profit, driving the price toward equilibrium. When all information is available, all profit opportunities have been exploited and all prices are correct and reflect market fundamentals. This is because the price reflects all information about intrinsic value. The result being that, since all information is known and reflected in the price, no agent can improve his forecast of the distribution of prices given the information provided by the market

. At such a state, expectations are both rational and accurate.

Distinction btw rationality and accuracy

A basic assumption of the rational expectations theory is that every individual makes the most efficient use of all information available. However, an important caveat is that information can be expensive, and often individuals must decide rationally without all the necessary information. Without all information, expectations can be rational and still quite inaccurate

Distinction between accuracy and bias

Although rational expectations may not be very accurate, the theory assumes that they will nevertheless be unbiased. Bias in an economic forecast is a predictable difference between the forecast and the events.

If the average forecast differs from the average of the events, this difference is predictable and the forecasts are said to be biased. Thus, since rational expectations are unbiased, those forecasts made without all the necessary information will be rational, but the agent making the forecast can still be surprised by the price and production changes of an item/market/industry.

The competitive equilibrium

The competitive general equilibrium tries to give an understanding of the whole economy using a "bottom-up" approach, starting with individual markets and agents, as a microeconomic approach. The rational expectations theory is based off this microeconomic approach, where it assumes that each individual agent is capable of quickly adapting to market changes and solving for the competitive equilibrium. This bottom-up approach and the concept of quick adaptation have been the source of much criticism about the rational expectations theory.

II. Flaws

Application of rational expectation to aggregate behavior

The main idea behind the rational expectations hypothesis is to consistently extend the principle of individual rationality from the problem of the allocation of resources.

The problem is the hypothesis's application to aggregate behavior. Even if all individual agents have rational expectations, the representative corporation/household/industry describing these behavior may not collectively make efficient use of all given information. Hence, in the aggregate, agents may not satisfy rational assumptions, and hence does not have macroeconomic applicability.

The rational expectation accounts only for rationing by price

The rational expectation theory is inapplicable with the law of diminishing occurrence.