Rational Expectations Theory
The Rational Expectations Hypothesis (REH) emerged to deal with the weaknesses of the Adaptive Expectations Hypothesis (AEH). Rational expectations ensures internal consistency and assumes the model’s predictions are valid. This assumption is used especially in many Macroeconomic models. Rational expectations differs from rational choice under uncertainty. This way of modelling was first outlined by John F. Muth in 1961 but later became popular when it was used by Robert Lucas.
The Rational Expectations theory says that economic agents use all the information available to them in forecasting the future. If their forecast proves to be wrong they suffer a loss of utility and fail to maximise their return. They have, therefore an incentive to obtain more and better information so that the mistakes are not repeated. It is true that forecast or decisions of economic agents are not always based on accurate information but their errors will not be systematic.
Lucas questioned the assumptions behind the Phillips curve, which had been thought to show that a government can lower the rate of unemployment by increasing inflation. According to the Phillips curve, higher inflation causes wages to rise more quickly, thereby fooling unemployed workers into thinking that the higher nominal wages are generous when, in fact, they are simply inflation-adjusted wages. Therefore, the unemployed take jobs more quickly, and the unemployment rate falls.
Defining Rational Expectations:
Since the publication of the seminal article on rational expectations (RE) by John Muth (1961), a variety of definitions have been proposed for this concept. Although a definitions cannot be wrong, some ways of definitions things can be more fruitful than others. There are two possible sort of definitions one weak and one strong.
Under the weak-form definitions of RE, the concept of RE essentially reduces to an assumption that agents make optimal use of whatever information they have to form their expectations. This is viewed by many economists as a natural extension of the usual postulate in economic theory that — unless there is good empirical evidence to the contrary one should presume that agents will always strive to bring their expectations into consistency with their information. Under strong form of RE economic agents are generally presumed to have a great deal more information than would actually be available to any econometrician who test these models on the basis of data.
The RE theory is based on the following Assumptions:
1. The errors therefore are not systematic. Forecasts are made on the basis of a correct model of the economy. In the course of correcting past and current mistakes we may overshoot so that our response is greater than it would be if we has perfectly accurate information. RE theory assumes that errors we make in any one period or one decision will be randomly distributed, in an assumed normal distribution.
2. Economic agents (People) understand the Natural Rate of Unemployment (NRU) and have other relevant information about the economy.
3. On the basis of Weak version of the theory people immediately realise the impact of government decision and forecasts future rate of inflation on the basis of growth in money supply announced by the government.
4. People understand how the government manipulates its monetary policy whenever unemployment rises above NRU and immediately revise their expectations of inflation accordingly.
5. Rational Expectations theory assumes that labour markets always clear and the level of output and employment would always be at the NRU.
6. It is the expected real wage not the actual real wage which determine the labour market decisions. The experience teaches them to avoid systematic errors.
7. All economic agents might not be making mistakes and experience long run increase in real wages following increase in money supply. People may realize at a later stage that the increase was not real but they might continue to remain in the employment. It is difficult to obtain accurate and correct information.
According to this theory the monetary stabilization policy which follows a systematic rule has no effect on output and employment. The policy is well anticipated by people who revise their expectations of inflation accordingly. The entire effect of the policy falls on prices leaving output and employment unchanged. The main implication of this theory is that in short run there may be some trade-off between inflation and unemployment but in the long run there is no impact of the systematic policy. The RE theory assumes that people change their expectations more quickly and use all available information in forecasting. This information includes:
The theory of rational expectations (RE) is a collection of assumptions regarding the manner in which economic agents exploit available information to form their expectations. In its stronger forms, RE operates as a coordination device that permits the construction of a “representative agent” having “representative expectations.” The weak form of the RE goes something like this: People have rational expectations if their forecast is consistent with the real world they live in. For weak assumptions economic agents need not be an expert economist. Just on the basis of their past observance they may predict a policy menu as we have repeated exposure to such situations in our day to day life.
Although the discussion on rational expectations has invited divergent views there is an appealing acceptance of the theory from a broad range of economists largely because of its theoretical appeal and perhaps due to lack of better alternative. Much of the existing evidence significantly implies that the majority of the agents form adaptive expectations, but there is equally enough evidence in support of rational expectation hypothesis. For example evidence of forecast of financial markets prices is often considered to be a reflection of the market absorption of all the information available hence making capital market more efficient than other markets. Other markets are still not so perfect and therefore markets do not clear. There is a little disagreement among modern economists that people do indeed attempt to anticipate inflation. Keynesians maintain that reactions to a policy change will be slow and indecisive and their behavior is entirely rational. They also believe in wage rigidity on account of many institutional factors. Wages and prices are set in a long-term contract and cannot be renegotiated frequently. Because of these rigidities, Keynesians argue that discretionary monetary and fiscal policy should be used to stabilize the economy.
Whereas in New Classical macroeconomic model, price surprises affect real output because people confuse nominal wage and price changes with real wage and relative price changes. Keynesians believe that people have information on general price movements and the price surprise may not last long.
 Robert E. Lucas Jr. is an American economist who won 1995 Nobel Prize in economics for developing and applying the theory of Rational Expectations an econometric hypothesis.
 Leigh Tesfatsion, “Introductory Notes on Rational Expectations”