Rational Expectation Hypothesis and its Critique | UGC NET Economics – Notes

Introduction

• The rational expectations hypothesis is widely used in macroeconomics. According to this hypothesis, economic agents use all available information to make predictions about economic variables. In addition, this hypothesis says that economic agents, along with available information and their experience, use their human rationality to predict the future value of an economic variable. They are well aware of it that predictions may not be correct. However, they learn from mistakes and improve their predictions for the future. This hypothesis not only applies to formulate expectations about inflation and income but also explains the formation of a wide range of economic variables.

• Rational expectations hypothesis 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.

Concept of Rational Expectations

• In the middle of the twentieth century many economists were of the view that theories based on rational behaviour were inadequate to explain observed phenomena. The argument of Muth was the exact opposite of this, i.e., existing economic models did not assume enough rational behaviour. The rationality of economic thinking can be ensured by introducing the expectations of economic variables in models used to explain human behaviour.

• Given the economic model, expectations are rational if actual values of variables, on average, are equal to the expected values of variables. For example, suppose there is a producer with rational expectations and (s)he performs the following thought experiments: what price should I expect, which is equal to everyone’s expected price? The producer takes into account various factors for this exercise. These factors could be the anticipated supplies by others, behaviour of other producers, inflation, etc. After consideration of all these, (s)he computes the price that will prevail in future.

• Milton Friedman emphasised that economic agents act as if they are maximising profit/utility. According to Muth, people do not work with the system of equations that economists use for maximisation of profit or utility. Further, individuals do not have similar expectations; they differ in their beliefs. However, individuals’ expectations should be distributed around the actual value of the variable to be forecasted. In this sense the anticipations of an average individual should be the expected value of the variable.

• There are two versions of the rational expectations hypothesis: weak and strong.

  • In the weak version, it is assumed that people have access to limited information; but they make best use of the information. Let us take a concrete example. You buy wheat flour (atta) every week for household consumption. You do not know the relative prices and nutrient levels of all the brands of wheat flour available in the market. With limited information available to you, however, you usually stick to the same brand (and may be the same shop, without knowing that other shops are charging a lower price!). Individuals however vary in their decision-making. They do not stick to the same brand. Thus there is no systematic error in their choice. When we take the expected value (that is, the average value) of a variable, it is usually not different from its actual value.

  • In the strong version of rational expectations hypothesis, it is assumed that people have access to all information. Decisions taken are based on all information. Thus, expected value of a variable is equal to its actual value. Any error in forecast is due to unexpected developments.