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THE CONCISE ENCYCLOPEDIA OF ECONOMICSRATIONAL EXPECTATIONS

Thomas SargentWhile rational expectations is often thought of as a school of economic thought,it is better regarded as a ubiquitous modeling technique used widelythroughout economics.

The theory of rational expectations was first proposed by John F. Muth ofIndiana University in the early 1960s. He used the term to describe the manyeconomic situations in which the outcome depends partly on what people

expect to happen. The price of an agricultural commodity, for example, dependson how many acres farmers plant, which in turn depends on the price farmersexpect to realize when they harvest and sell their crops. As another example,the value of a currency and its rate of depreciation depend partly on whatpeople expect that rate of depreciation to be. That is because people rush todesert a currency that they expect to lose value, thereby contributing to its lossin value. Similarly, the price of a stock or bond depends partly on whatprospective buyers and sellers believe it will be in the future.

The use of expectations in economic theory is not new. Many earliereconomists, including A C PIGOU, JOHN MAYNARD KEYNES, and JOHN RHICKS, assigned a central role in the determination of the business cycle topeoples expectations about the future. Keynes referred to this as waves ofoptimism and pessimism that helped determine the level of economic activity.But proponents of the rational expectations theory are more thorough in theiranalysis of expectations.

The influences between expectations and outcomes flow both ways. In formingtheir expectations, people try to forecast what will actually occur. They havestrong incentives to use forecasting rules that work well because higherPROFITS accrue to someone who acts on the basis of better forecasts, whetherthat someone is a trader in the STOCK MARKET or someone considering thepurchase of a new car. And when people have to forecast a particular price overand over again, they tend to adjust their forecasting rules to eliminateavoidable errors. Thus, there is continual feedback from past outcomes tocurrent expectations. Translation: in recurrent situations the way the futureunfolds from the past tends to be stable, and people adjust their forecasts toconform to this stable pattern.

The concept of rational expectations asserts that outcomes do not differsystematically (i.e., regularly or predictably) from what people expected themto be. The concept is motivated by the same thinking that led Abraham Lincolnto assert, You can fool some of the people all of the time, and all of the people

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some of the time, but you cannot fool all of the people all of the time. From theviewpoint of the rational expectations doctrine, Lincolns statement gets thingsright. It does not deny that people often make forecasting errors, but it doessuggest that errors will not persistently occur on one side or the other.

Economists who believe in rational expectations base their belief on thestandard economic assumption that people behave in ways that maximize theirutility (their enjoyment of life) or profits. Economists have used the concept ofrational expectations to understand a variety of situations in which speculationabout the future is a crucial factor in determining current action. Rationalexpectations is a building block for the random walk or efficient marketstheory of securities prices, the theory of the dynamics of hyperinflations, thepermanent income and life-cycle theories of consumption, and the design ofeconomic stabilization policies.

The Efficient Markets Theory of Stock PricesOne of the earliest and most striking applications of the concept of rationalexpectations is the efficient markets theory of asset prices. A sequence ofobservations on a variable (such as daily stock prices) is said to follow arandom walk if the current value gives the best possible prediction of futurevalues. The efficient markets theory of stock prices uses the concept of rationalexpectations to reach the conclusion that, when properly adjusted fordiscounting and dividends, stock price changes follow a random walk. The

chain of reasoning goes as follows. In their efforts to forecast prices, investorscomb all sources of information (see INFORMATION AND PRICES), includingpatterns that they can spot in past price movements.

Investors buy stocks they expect to have a higher-than-average return and sellthose they expect to have lower returns. When they do so, they bid up theprices of stocks expected to have higher-than-average returns and drive downthe prices of those expected to have lower-than-average returns. The prices ofthe stocks adjust until the expected returns, adjusted for risk, are equal for allstocks. Equalization of expected returns means that investors forecasts becomebuilt into or reflected in the prices of stocks. More precisely, it means that stockprices change so that after an adjustment to reflect dividends, the time value ofmoney, and differential risk, they equal the markets best forecast of the futureprice. Therefore, the only factors that can change stock prices are randomfactors that could not be known in advance. Thus, changes in stock pricesfollow a random walk.

The random walk theory has been subjected to literally hundreds of empiricaltests. The tests tend to support the theory quite strongly. While some studieshave found situations that contradict the theory, the theory does explain, atleast to a very good first approximation, how asset prices evolve (see EFFICIENTCAPITAL MARKETS).

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The Permanent Income Theory of ConsumptionThe Keynesian consumption function (see KEYNESIAN ECONOMICS and NEWKEYNESIAN ECONOMICS) holds that there is a positive relationship betweenpeoples consumption and their income. Early empirical work in the 1940s and1950s encountered some discrepancies in the theory, which MILTON FRIEDMANsuccessfully explained with his celebrated permanent income theory ofconsumption. Friedman built on IRVING FISHERs insight that a personsconsumption ought not depend on current income alone, but also on prospectsof income in the future. Friedman posited that people consume out of theirpermanent income, which can be defined as the level of consumption that canbe sustained while leaving wealth intact. In defining wealth, Friedmanincluded a measure of human wealthnamely, the PRESENT VALUEof peoplesexpectations of future labor income.

Although Friedman did not formally apply the concept of rational expectationsin his work, it is implicit in much of his discussion. Because of its heavyemphasis on the role of expectations about future income, his hypothesis was aprime candidate for the application of rational expectations. In worksubsequent to Friedmans, John F. Muth and Stanfords Robert E. Hallimposed rational expectations on versions of Friedmans model, withinteresting results. In Halls version, imposing rational expectations producesthe result that consumption is a random walk: the best prediction of futureconsumption is the present level of consumption. This result encapsulates the

consumption-smoothing aspect of the permanent income model and reflectspeoples efforts to estimate their wealth and to allocate it over time. Ifconsumption in each period is held at a level that is expected to leave wealthunchanged, it follows that wealth and consumption will each equal their valuesin the previous period plus an unforecastable or unforeseeable random shockreally a forecast error.

The rational expectations version of the permanent income hypothesis haschanged the way economists think about short-term stabilization policies (suchas temporary tax cuts) designed to stimulate the economy. Keynesianeconomists once believed that tax cuts boost disposable income and thus causepeople to consume more. But according to the permanent income model,temporary tax cuts have much less of an effect on consumption thanKeynesians had thought. The reason is that people are basing theirconsumption decision on their wealth, not their current disposable income.Because temporary tax cuts are bound to be reversed, they have little or noeffect on wealth, and therefore have little or no effect on consumption. Thus,the permanent income model had the effect of diminishing the expendituremultiplier that economists ascribed to temporary tax cuts.

The rational expectations version of the permanent income model has beenextensively tested, with results that are quite encouraging. The evidence

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indicates that the model works well but imperfectly. Economists next extendedthe model to take into account factors such as habit persistence inconsumption and the differing durabilities of various consumption goods.Expanding the theory to incorporate these features alters the pure randomwalk prediction of the theory and so helps remedy some of the empiricalshortcomings of the model, but it leaves the basic permanent income insightintact.

Expectational Error Models of the Business CycleA long tradition in business cycle theory has held that errors in peoplesforecasts are a major cause of business fluctuations. This view is embodied inthe PHILLIPS CURVE (the observed inverse correlation between UNEMPLOYMENTand INFLATION), with economists attributing the correlation to errors peoplemake in their forecasts of the price level. Before the advent of rationalexpectations, economists often proposed to exploit or manipulate thepublics forecasting errors in ways designed to generate better performance ofthe economy over the business cycle. Thus, Robert Hall aptly described thestate of economic thinking in 1973 when he wrote:

The benefits of inflation derive from the use of expansionary policy to trickeconomic agents into behaving in socially preferable ways even though theirbehavior is not in their own interest.... The gap between actual and expectedinflation measures the extent of the trickery.... The optimal policy is not nearly

as expansionary [inflationary] when expectations adjust rapidly, and most ofthe effect of an inflationary policy is dissipated in costly anticipated inflation.

Rational expectations undermines the idea that policymakers can manipulatethe economy by systematically making the public have false expectations.ROBERT LUCAS showed that if expectations are rational, it simply is notpossible for the government to manipulate those forecast errors in a predictableand reliable way for the very reason that the errors made by a rationalforecaster are inherently unpredictable. Lucass work led to what hassometimes been called the policy ineffectiveness proposition. If people haverational expectations, policies that try to manipulate the economy by inducingpeople into having false expectations may introduce more noise into theeconomy but cannot, on average, improve the economys performance.

Design of Macroeconomic PoliciesThe policy ineffectiveness result pertains only to those economic policies thathave their effects solely by inducing forecast errors. Many government policieswork by affecting margins or incentives, and the concept of rationalexpectations delivers no policy ineffectiveness result for such policies. In fact,the idea of rational expectations has been used extensively in such contexts to

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study the design of monetary, fiscal, and regulatory policies to promote goodeconomic performance.

The idea of rational expectations has also been a workhorse in developingprescriptions for optimally choosing MONETARY POLICY. Truman Bewley andWilliam A. Brock have been important contributors to this literature. Bewleysand Brocks work describes precisely the contexts in which an optimalmonetary arrangement involves having the government pay interest onreserves at the market rate. Their work supports, clarifies, and extendsproposals to monetary reform made by Milton Friedman in 1960 and 1968.

Rational expectations has been a working assumption in recent studies that tryto explain how monetary and fiscal authorities can retain (or lose) goodreputations for their conduct of policy. This literature has helped economists

understand the multiplicity of government policy strategies followed, forexample, in high-inflation and low-inflation countries. In particular, work onreputational equilibria in macroeconomics by Robert Barro and by DavidGordon and Nancy Stokey showed that the preferences of citizens andpolicymakers and the available production technologies and tradingopportunities are not by themselves sufficient to determine whether agovernment will follow a low-inflation or a high-inflation policy mix. Instead,reputation remains an independent factor even after rational expectations havebeen assumed.

About the AuthorThomas J. Sargent is a senior fellow at Stanfords Hoover Institution and aneconomics professor at New York University. He is one of the pioneers in thetheory of rational expectations.

Further ReadingFischer, Stanley, ed. Rational Expectations and Economic Policy. Chicago:

University of Chicago Press, 1980.Lucas, Robert E. Jr. Models of Business Cycles.Oxford: Basil Blackwell, 1987.Muth, John A. Rational Expectations and the Theory of Price Movements.Econometrica29, no. 6 (1961): 315335.Sargent, Thomas J. Rational Expectations and Inflation. New York: Harperand Row, 1986.Sheffrin, Steven M. Rational Expectations. 2d ed. Cambridge: CambridgeUniversity Press, 1996.