Andrew Foerster

English

Research Papers in Economics

6 Region Focus • Summer 2006
M
any economic decisions in life depend upon predic-
tions or expectations about the future. Anew college
graduate’s choice of a career often depends on how
he thinks earnings in certain fields will change over coming
years. Investors choose stocks based upon their views of likely
changes in returns. A farmer decides how much corn to plant
according to his expectations of future prices.
In each of these examples, the effect of expectations on cur-
rent behavior is clear. However, in each case, future prices
depend upon the actions of a large group of individuals making
current decisions. Earnings in a field will depend
upon how many college graduates choose that
occupation and how much demand exists for
those skills; the price of a stock will depend
upon how many shares are available and
whether investors want to buy or sell them;
and the price of corn will depend upon how
much corn farmers have harvested and
how much households wish to consume.
The rational expectations hypothesis is
important for studying forward-looking
decisions and markets. It rests on the
premise that any discrepancies between
expectations and outcomes are not “sys-
tematic.” In other words, people do not
make the same mistakes over and over,
constantly misjudging future events. Rational expectations the-
ory does not assume that people have perfect foresight, but it
does assume that decisionmakers understand how future prices
will be determined — for instance, the more corn is harvested,
the lower the price will tend to be — and do the best job possi-
ble forecasting the future with the information available to
them now.
Since the idea of rational expectations depends on systemat-
ic discrepancies between outcomes and expectations, events
that are “surprises” can have large effects. For instance, farmers
understand that droughts are possible but infrequent. As a
result, when a drought occurs, they are unlikely to have predict-
ed its effects on supply and, hence, prices for the current season.
This is a surprise for which rational expectations theory can
account. What rational expectations does not allow, however, is
for farmers to systematically misjudge the frequency of
droughts and their effects on crop yields and prices. That is, one
would expect farmers to understand that if a drought occurs,
yields will be low and prices will be high.
The same is true when it comes to investors. Certain stocks
may be undervalued at certain points in time. But overall,
investors are unlikely to consistently underestimate the future
prices of equities. If there were such a discrepancy, savvy
investors would realize that their expectations were too low, buy
more stock, and drive up prices. 
Rational expectations can also help explain people’s 
consumption patterns. Consider a person in mid-career who has
been laid off, but expects to find a new job in the next few
months. Should this person, whose income has just dropped sig-
nificantly, make an equal cut in his immediate consumption?
Economists would argue there may be no need for a big cut,
because he can use debt or savings for a short while, then repay
the debt or replenish savings once he is employed again. 
People tend to be forward-looking
when it comes to public policy changes 
as well. For instance, temporary tax cuts
intended to stimulate the economy may in
fact be met with only slight increases 
of consumption, as people expect future
tax rates to return to their previous 
higher level to raise revenue. 
In addition to fiscal policy, rational
expectations theory has significant impli-
cations for monetary policy. Many
economists used to believe that there was
an exploitable trade-off between unemploy-
ment and inflation: The Fed could cut
interest rates, stimulate the economy, and
lower unemployment without having to
worry about runaway inflation. But this policy only worked until
people figured out that inflation and expansionary policy go
hand in hand. As a result, rational expectations suggested the
Fed simply keep inflation low and not try to exploit possible
trade-offs.
However, the Fed could have a short-term trade-off by unex-
pectedly letting inflation rise or fall. Alas, this policy would
reduce the Fed’s credibility, causing people to expect higher
inflation. What’s more, people would raise their expectations of
a “policy surprise,” making actions, and therefore results, more
volatile in the future. Along these lines, Robert Lucas developed
the “policy ineffectiveness proposition,” which states that
expected policy shifts will have little effect on the economy, as
people will rationally adjust their behavior to limit the effect of
the policy.  
There exist some challengers to rational expectations theory.
Behavioral economists, for example, tend to view people as rel-
atively myopic. Still, rational expectations theory today
occupies a central place in how most economists think about
how people look to the future. For policy institutions such as
the Fed, rational expectations theory suggests it is wise to be
predictable with policy changes and to not try to manipulate the
economy through policy surprises.                     RF
JARGONALERT
Rational Expectations
BY ANDREW FOERSTER
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RF Summer 2006v27  7/24/06  12:52 PM  Page 6

Jargon alert : Rational expectations

http://www.richmondfed.org/publications/research/region_focus/2006/summer/pdf/jargon_alert.pdf

Jargon alert : Rational expectations

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