Rational expectations

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid.[1] Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models.

Since most macroeconomic models today study decisions under uncertainty and over many periods, the expectations of individuals, firms, and government institutions about future economic conditions are an essential part of the model. To assume rational expectations is to assume that agents' expectations may be wrong, but are correct on average over time. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased and collectively use all relevant information in forming expectations of economic variables. This way of modeling expectations was originally proposed by John F. Muth (1961)[2] and later became influential when it was used by Robert Lucas Jr. in macroeconomics.

Deirdre McCloskey emphasizes that "rational expectations" is an expression of intellectual modesty:[3]

Muth's notion was that the professors [of economics], even if correct in their model of man, could do no better in predicting than could the hog farmer or steelmaker or insurance company. The notion is one of intellectual modesty. The common sense is "rationality": therefore Muth called the argument "rational expectations".

Hence, it is important to distinguish the rational-expectations assumption from assumptions of individual rationality and to note that the first does not imply the latter. Rational expectations is an assumption of aggregate consistency in dynamic models. In contrast, rational choice theory studies individual decision making and is used extensively in, among others, game theory and contract theory.[4] In fact, Muth cited survey data exhibiting "considerable cross-sectional differences of opinion" and was quite explicit in stating that his rational-expectations hypothesis does not assert... that predictions of entrepreneurs are perfect or that their expectations are all the same. In Muth's version of rational expectations, each individual holds beliefs that are model inconsistent, although the distribution of these diverse beliefs is unbiased relative to the data generated by the actions resulting from these expectations.