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1. Learning Outcomes

After studying this module, you shall be able to

Know the concept of rational expectations

Understand the implications of rational expectations
Evaluate the short comings of rational expectations
Analyse random walk hypothesis

2. Introduction to Rational Expectation Theory

During 1950s, Herbert. A. Simon and John Muth were jointly working on the solution to
inventory management and production for a production firm, but with two opposing

limited ability to in making appropriate decisions, whereas, Muth propagated the idea of
rational expectations.

Expectations, as simply explained is what people can estimate of a variable in its future
based on some set of information available them about it. It then relies on the fact how
accurate their expectations were how to they revise their expectations and how very it
adjusted with the actual value of the variable in future. For example, prices, if people
base their information set on previous data in inflation and price movements, and
if say, prices have been growing steadily over the years, people, thus make expectations
about the price in future to also move in the same trend and hence, rise steadily in the
future. This very concept of basing the expectation son lagged information is the concept
of adaptive expectations and is the sheer opposite of what rational expectation is.

Another example of formulation of expectation is found in well-known Cobweb model,

wherein, the model describes the movement of the agriculture prices based on lagged
prices in agriculture (w was given by Nerlove, 1958). Another example is the dynamic
hyperinflation model, Cagan model (1956), in which velocity of money is inversely
dependent on the expected inflation and expected inflation is function of past inflations.
His model has the property that an increase in the expected inflation, will lead to increase
in velocity of money and when velocity rises, prices will rise. With rise in prices, as
expected inflation is function of past inflation, the rise in prices will further increase
expectations about the inflation in future and hence a vicious circle of expected inflation,
velocity of money and prices has been explained in Cagan model.

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What is rational expectation?

To simply explain rational expectation is to say, according to the doctrine of rational

expectation, people when making future estimated values of a variable act rationally and
do not tend to make systematic errors in predicting the future value of the variable with
the given set of information. Progress in economics requires how expectation of a
variable is formed.

J.Muth suggested that economists are often interested in how expectations might change
in certain circumstances, which means if an event occurs, what impact will it have on the
expected value of the variable. To this he said, economists should not be satisfied with
the fixed expectation formulas that do not allow for change when, the structure of the
system changes. If underlying economic system changes, it will be wise to expect that
there will be change in the way economic actors make their expectations. Hence, Muth
suggested, what rational, should be done in a
that it was possible to require economic agents to form expectations of economic
variables by using the very model that actually determines these variables.

The REH is the most popular approach to modelling expectations in mainstream

economics. The REH can be viewed as an attempt to provide neoclassical economics
with a theory of expectations and beliefs formation that is a priori consistent with the
optimization hypothesis. We owe its original formulation to Muth (1961) who suggests
that expectations should be modelled in a way that allows them to change endogenously
when the structure of the system alters. According to Muth, the REH implies that
economic agents´ subjective expectations are, on average, equal to the true values of the
variables. In other words, it is only the average of economic agents´ forecasts that will be
equal to the mathematical expectation of the variable. Thus, the forecast of a given
individual may not coincide with the latter.

A capsule characterization of rational expectations contains the following themes: (1) In

individuals make no systematic forecast errors; (2) Individuals use all available
information (as defined by the researcher) in forming forecasts; (3) Expectations vary

belief of the
theory and are often espoused by its advocates.

3. Model of Rational Expectation

Explaining the rational expectation hypothesis using an example:

The market equations take the form

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where: represents the number of units produced in a period lasting as long as the
production lag, is the amount consumed, is the market price in the period, is
the market price expected to prevail during the period on the basis of information
available through the (t -1)'st period, is an error term, showing, for example- variations
in yields due to weather. The values that are used are the deviations from the equilibrium
values.

By eliminating the quantity variables from the equation to give the following

The error term is unknown at the time the production decisions are made, but it is known-
and relevant-at the time the commodity is purchased in the market. The prediction of the
model is found by replacing the error term by its expected value, conditional on past
events. If there is no serial correlation in error terms and , we obtain the
following,

If the forecast of the theory were significantly better than the expectations of the firms,
then there would be opportunities for the "insider" to benefit from the knowledge-by
inventory speculation if possible, by operating a firm, or by selling a price forecasting
service to the firms. The profit opportunities would no longer exist if the aggregate
expectation of the firms is the same as the forecast of the theory.

Referring to above equations, it can be observed that if , the rationality

assumption in above equation implies that =0, or that the expected price equals the
equilibrium price. Till the time there are disturbances which are happening on the supply
function, quantity and price would move along the demand curve from one period to the
next. The problem we have been discussing till now is not of great empirical interest,
because the shocks were assumed to be totally unpredictable. For most markets it is
desirable to allow for income effects in demand & alternative costs in supply, with the
assumption that part of the shock variable may be predicted on the basis of prior
information. By retracing our steps from above equations, we see that the expected price
would be;

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If the shock is observable, then the conditional expected value or its regression estimate
may be found directly. If the shock is not observable, it must be estimated from the past
history of variables that can be measured.

4. Rational Expectation in Theory

Implications of rational expectations:

Muth framed his rational expectations hypothesis (REH) in terms of probability

distributions: Expectations of firms (or, more generally, the subjective probability
distribution of outcomes) tend to be distributed, for the same information set, about the
of outcomes). But
Muth was also very open with the non-descriptive character of his concept.

According to him the hypothesis of rational expectations does not assert that the scratch
work of entrepreneurs resembles the system of equations in any way; nor does it state that
predictions of entrepreneurs are perfect or that their expectations are all the same. To
Muth its main usefulness was its generality and ability to be applicable to all sorts of
situations irrespective of the concrete and contingent circumstances at hand. It is
noteworthy that Lucas (1972) did not give any further justifications for REH, but simply
applied it to macroeconomics. In the hands of Lucas and Sargent it was used to argue that
government could not really influence the behavior of economic agents in any systematic
way. In the 1980s it became a dominant model assumption in New Classical
Macroeconomics and has continued to be a standard assumption made in many
neoclassical (macro)economic models most notably in the fields of (real) business

In rational expectation hypothesis models new information is typically presented as

something only reducing the variance of the parameter estimated. But if new information
means truly new information it actually could increase our uncertainty and variance
(information set (A, B) => (A, B, C)). Truly new information gives birth to new
probabilities, revised plans and decisions something the REH cannot account for with
its finite sampling representation of incomplete information.

Shortcomings of rational expectation hypothesis:

Models based on rational expectation hypothesis impute beliefs to the agents that are not
based on any real informational considerations, they are simply stipulated to make the
models mathematically and statistically tractable. Of course one can make assumptions
based on tractability, but then one also has to take into account the required trade-off in
terms of the capacity to make relevant and valid statements on the intended target system.

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Mathematical tractability cannot be the decisive authority in science when it comes to

model real world target systems. Of course, one could possibly agree to REH if it had
produced lots of established predictions and excellent explanations. But it has done
nothing of the kind. Therefore the trouble of proof is on those who still want to use
models built on ridiculously unreal assumptions models devoid of obvious empirical
interest.
In actuality REH is a to a certain extent harmful modeling assumption, since it
contributes to perpetuating the ongoing transformation of economics into a kind of
science-fiction-economics. If economics is to direct us, facilitate us make forecasts,
explicate or better comprehend real world phenomena, it is in reality next to worthless.

REH presupposes fundamentally for reasons of consistency that agents have full
knowledge of all of the relevant probability distribution functions. And in order to
incorporate learning in these models to catch the heat off some of the criticism
launched against it up to date it is always a very restricted kind of learning that is
measured. A learning where truly unexpected, surprising, new things never take place,
but only a rather mechanical updating escalating the accuracy of previously existing
information sets of existing probability functions.

In rational expectations model, it is presumed a consistent behavior, where expectations

do not display any persistent errors. In the world of REH we are always, on average,

possibility (danger) of making mistakes that may turn out to be systematic. It is

presumably one of the main reasons why we put so much emphasis on learning in our
modern knowledge societies.

as th
risk and uncertainty as equivalent entities. But in the real world, it is not possible to just
assume that probability distributions are the right way to characterize, understand or

REH simply will not

do. In those circumstances it is not a useful assumption. The reason is that under those
circumstances the future is not like the past, and henceforth, we cannot use the same
probability distribution if it at all exists to describe both the past and future.

5. Meaning of Random Walk Theory

The Random-Walk Hypothesis is due t

model & Permanent income hypothesis, in which forward-
consumption on expected future income. To this Hall adds the assumption of rational
expectations, that people use all available information to forecast future variables like
income. In the permanent income hypothesis as doctrine by Milton Friedman and Life
cycle hypothesis as doctrine by Modigliani, basically specified that household base their

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consumption on their permanent income and not on the transitory income. Thus, if PIH is
correct and consumers have rational expectations, then consumption should follow a
random walk that is changes in consumption should be unpredictable. A change in
income or wealth that was anticipated has already been factored into expected permanent
income, so it will not change consumption. Only unanticipated changes in income or
wealth that alter expected permanent income will change consumption. The
independence of consumption changes from expected changes in income is known as the
random-walk hypothesis of consumption. Notice that the random-walk hypothesis is not a
separate theory but rather an implication of the neoclassical model. It was first explored
in a seminal study by Robert Hall (1978).

The discussion of random walk hypothesis would be like, simple discrete-time model
with a zero rate of time preference and a zero interest rate. The zero interest rate implies
that the consumer can trade current for future consumption at a one-for-one rate in the
market. The zero rate of time preference assures that a consumer who is smoothing
consumption is indifferent about making that trade.

In the context of random walk hypothesis, Romer expresses the first-order condition for
utility maximization the marginal utility of consumption in period one must equal the

ons with the

mathematical expectation of the variable. Carrying the expectation operation through this
we can conclude that the expected value of consumption in all future years equals the
level of consumption in period one. According to this, it means that the consumer
chooses a perfectly flat consumption path from years 1 through T. It is simple due to the
assumptions that both the interest rate and the rate of time preference are zero. As we
know from our consumption analysis in the Ramsey growth model, utility-maximizing
consumers select a rising, flat, or falling time path of consumption depending on whether
the interest rate is greater
preference. Thus, the model is complicated even more when these assumptions are
relaxed, but the main idea still holds, that is, changes in consumption from one period to
the next do not depend on correctly anticipated changes in income. Romer explained
what causes change in consumption from period 1 to period 2. The change in the
expectation of its future income is based on information that becomes
available in period two. Thus, changes in expectations of income (even if they are
changes that are expected to happen in future periods) will cause the household to revise
its consumption path and make second-period consumption differ from first-period
consumption.

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6. Model of Random Walk Theory

is said
to random walk if value of x at time period t is its value at time period t-1 plus a random
term which is uncorrelated with the past random terms. In equation,

Where, is an i.i.d with mean zero. If , then is to follow random walk with a
drift. So the actual model is,

where
is is close to zero and is close to one and no variable
will be useful in predicting the consumption in current period to zero. In particular, this
means that the residual is uncorrelated with any variable whose value is known at t-1,
or earlier. Y changes, consumption changes only insofar as the changes in income were
unanticipated.

ially quite useful since it gives us a way of

checking whether people behave in a Keynesian way or whether they behave according
to the Rational Expectations/Permanent income Hypothesis. Yet more important his
equation relating the marginal utility of consumption today to the expected marginal
utility of consumption tomorrow is a vast simplication that enables us to solve for
consumption streams even in the presence of stochastic incomes. This allows us to
evaluate such things as the deadweight losses from capital income taxation even when
income is stochastic. It turns out that these deadweight losses are an order of magnitude
different when one takes into account the stochastic nature of income. In a nutshell, Hall
says it is exactly true if utility is quadratic and people have rational expectations and
maximize their intertemporal utility function that a test for the RE/PIH comes from the
regression. So unexpected changes in the policy can change consumption up to the extent
of its affect on the permanent income. Policies that have transitory on income have
transitory affect on consumption.

Summary of random walk hypothesis:

Theory of random walk is based on the Friedman's permanent income hypothesis and
theory of rational expectations. According to Friedman's permanent income hypothesis,
consumption depends primarily on permanent income. At any point of time in their

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lifetime, consumption is chosen by consumers based on their current expectations about

lifetime incomes. They would then change their consumption when they receive news
that causes them to change their expectations about their lifetime income. For eg., a
person getting an unexpected promotion would revise his expectations about lifetime
income upwards and thus consume more. As long as consumers use all the existing
information to assess their lifetime income, as long as they have rational expectations,
then they should only be surprised by events that were entirely unpredictable. Therefore,
changes in their consumption should be unpredictable as well. Hall (1978) tests this
theory using postwar aggregate US data and finds that past consumption data have no
power to predict future consumption as he was not able to reject the hypothesis that
lagged values of either income or consumption cannot predict the change in consumption.
Hall's theory is based on several assumptions that he uses in testing the stochastic version
of life-cycle & permanent income hypotheses and which can be challenged. Firstly, there
is the simplifying assumption of a quadratic utility function, which implies that marginal
utility is linear in consumption. As a consequence, the individual consumption choice
shows certainty equivalence, which means that individuals ignore the variation of
consumption and act as if future consumption was as the conditional mean. Hall further
assumes that consumer want to keep marginal utility & therefore consumption constant
over time.

ECONOMICS Paper 6: Advanced Macroeconomics