Rational Expectations

Imagine the Federal Reserve is deciding to pursue an expansionary monetary policy. You know that this will increase the price level in the economy. Most people would demand higher wages. How would you react when you find out that the government is pursuing an expansionary monetary policy? Would you ask your boss to increase your salary?

According to rational expectations, you would ask your boss to increase your salary as you make the optimal choice with all the available information. But does this happen with everyone? What are rational expectations, and how do they impact our economy?

You'll find out the answer to these questions and much more by reaching the bottom of this article!

Rational Expectations Definition

Before jumping into the definition of rational expectations, let's start with a bit of history!

In the 1970s, a concept known as rational expectations exerted a significant amount of influence on the field of macroeconomics. John Muth first presented the theory of rational expectations in 1961.¹

Rational Expectations Theory

The rational expectations theory started when John Keynes argued that the expectations individuals have about the future were capable of influencing the economy. That is to say that people were adjusting their economic decisions based on what they expected the economy's future to be like, which in turn, affected the state of the economy at that time.

The ideas and arguments of Keynes were further developed into what is known today as the rational expectations theory by John F. Muth in 1961.

According to the theory of rational expectations, people's expectations about the economy's future can influence the state of the economy in the present.

Rational Expectations Monetary Policy

Rational expectations play an important role when considering the impacts of monetary policy. Accepting the rational expectations assumption can bring about considerable shifts in perceptions about the efficacy of aggressive macroeconomic policy.

Previous theories, such as the natural rate hypothesis, suggest that the government can influence real economic variables such as total output produced and the unemployment rate in the economy, at least in the short run.

On the other hand, rational expectations bring about another view on monetary policy. The rational expectations suggest that monetary policy does not impact real variables such as total output produced or the unemployment rate.

That's because individuals will demand higher wages immediately when expecting an increase in inflation, which would increase the cost of production and the price level. Additionally, the increase in wages would not contribute to lowering unemployment due to the increase in production costs.

According to rational expectations, there is no short-run or long-run effect of monetary policies on real variables such as GDP or unemployment rate. Rather, there is an exclusive impact on the price level in the economy.

Rational Expectations Equilibrium

We can use the AD-AS model framework to understand the rational expectation equilibrium.

We've considered the fact that rational expectations imply that macroeconomic policy does not affect real variables such as GDP or unemployment. Still, they do have an impact on nominal variables such as the price level.

Rational expectations imply that people make optimal choices based on all the information they have available at hand.

Take a look at Figure 1 below.

Fig. 1 - Rational expectations equilibrium

Figure 1 shows the economy which is in equilibrium at point 1, where the aggregate demand (AD₁), short-run aggregate supply (SRAS₁), and long-run aggregate supply (LRAS) intersect with one another. At point 1 of equilibrium, there is a Y₁ level of goods and services produced, and the overall price level is at P₁.

Now assume that the Federal Reserve decides to pursue an expansionary monetary policy. To do so, it chooses to lower the discount rate. This drops the interest rate in the economy, making borrowing money cheaper. As a result, consumption increases, which shifts the aggregate demand curve to the right (from AD₁ to AD₂). This contributes to an increase in the price level (from P₁ to P₂), and the output produced increases from Y₁ to Y₂.

However, due to rational expectations assumption, when individuals find out that there will be expansionary monetary policy and higher inflation, they will demand higher wages. The increase in wages increases firms' production costs, leading to a shift to the left of the short-run aggregate supply from SRAS₁ to SRAS₂. This brings the equilibrium to point 3, where there is a higher price level (inflation), and output remains the same.

Although we've shown a step by step equilibrium adjustment, due to rational expectations, the equilibrium goes directly from point 1 to point 3 instead of point 2. As a result of rational expectations, there is no short-run or long-run change in the overall output produced.

Rational Expectations vs. Adaptive Expectations

To understand rational expectations vs. adaptive expectations, let's consider the meaning of adaptive expectations.

The main difference between rational expectations and adaptive expectations is that adaptive expectations make use of historical information or information from the preceding period. On the other hand, rational expectations make use of all the available information, past and present, to make a decision.

Predicting inflation is possible with the help of adaptive expectations. People often anticipate a higher rate of inflation in the year after one in which there was a rise in the overall level of inflation.

When there is a discrepancy between what people anticipate will happen and what does take place, those people's expectations about any given variable will shift. On the other hand, if what they expected turned out to be accurate, it is unlikely that they would adjust their expectations in the future. Adaptive expectations require that individuals update their expectations as each period passes.