Rational Expectation

Inspired by my classmate’s writing in responding a question about “Rational Expectation” that appeared in lately macroeconomics’ mid test, I decide to write the same topic. Be frankly, before I took the exam, I never heard the notion of “rational expectation” (ohh… poor me! இட்'ச definitely clear that I must increase time to “hitting the books – including journal, newspapar, etc”… :-D).

After two days of doing nothing because of suffering from midterm syndrome, fortunately, today, I got permission to borrow a book from a nice friend (thank you jelek!), a book that consists of several economics articles of Nobel Price receiver. Several of them talk about Rational Expectation.

Though the articles provided in book are not clear enough in explaining about The Rational Expecation, here I try to make summary on it. Basically, this writing is simply aimed to share while testing my knowledge about the topic I just read (lieur teu jiga dibaca sanes kituh…). To be honest, since now, I committed myself to write as many as I can as the way I choose to internalize all knowledge that I get from classes, discussions, books, newspaper or journal that I read. For this reason, I open with all critiques.

Background

To begin with, expectation is very essential in economics for every decision that deals with future always related to what people “expect” to happen in the future. If people expect to be wealthy in the future, they will consume more so that aggregate output will increase. If investor expects an increasing interest rate that can affect his loses in the long run, he will decrease his demand to bond. Basically, the theory of rational expectation is intended to explain about how people whom involed in economy activities perform their expectation.

Before we go further about rational expectation, we discuss first about what is “adaptive expectation” for the notion rational expectation was came up and developed from that idea. Adaptive expectation is expactation that people made based on the past information they have. In the other words, people make their expectation simply based on their past experiences without any considering to the present information. For this reason, adaptive expectation could be mislead.

Rational Expectation

Robert Lucas was well known as a Nobel Price receiver in economics for his theory about Rational Expectation. However, this theory firstly developed by John Muth that adopted from “adaptive expectation” as explained above. Rational expectation itself defines as optimum prediction or forcasting about future by using all information available. Eventhough, rational expectation is based on all available information, it could be faulty because of two reasons:

a. First, people aware about all available information but they are too lazy to work on making good forcast;

b. Second, people may not aware about relevan information so their prediction about future was misslead.

Why Theory of Rational Expectation is Important?

Principally, the answer to the question “why people try hard to work on their expectation” is simple that is for they won’t be lose. Just try to figure it out from the facts provided below: when a manufacture company knows that the level of interest rate affects their sales, if that company make wrong prediction about the level of interest rate, the company will receive lesser profit for they will produce too much or too less. For this reason, the company will use all its sources to get as much as information that can help them to predict the level of interest rate in the future.

Robert Lucas had applied his “rational expectation” theory to check why some policies failed. He critiques policy evaluation by using econometric application that involves mathematical equations which describes causalities among variables. According to Lucas, the involving of a policy changes the behaviour of people. This shows that the expectation of people change/influence that policy itself.

Expectation is important in economics decision making for not only household, firm but also organisation. The expectation is based on the expectation of inflation rate and labor supply in the future that influenced by expected level of wages. Generally, every individual in the economy is rational which means that they try to collect data and information as much as they can and use them to make plan or prediction about the future.

Several Critics over The Rational Expectation Theory

Eventhough rational expectation approach tend to cover the economic reality, there are several critiques upon this approach. First, because of complexity and dynamism of economy, people are doubted to make rational forcasting. Second, every person has different economic model so that rational expectation is different among one and others. Third, people are not always. Fourth, it’s not easy to formulate the rational expectation to a concrate macroeconomic model that can accommodate the changes of parameters in the model.

Conclusion

To sum up, the rational expectation is a sort of macroeconomic model that analyze the data available and used it to make prediction of future. It is intended to seek opportunities in the future by using all available information.

Sources:

Esai-Esai Nobel Ekonomi, KOMPAS