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Rational expectations theory defines these kinds of expectations as being identical to the best guess of the future (the optimal forecast) that uses all available information. However, without further assumptions, this theory of expectations determination makes no predictions about human behavior and is empty. Thus, it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. As a result, rational expectations do not differ systematically or predictably from equilibrium results. That is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random. In an economic model, this is typically modelled by assuming that the expected value of a variable is equal to the value predicted Arie
For example, suppose that P* is the equilibrium price in a simple market, determined by supply and demand. Then, the theory of rational expectations says that the expected price (Pe) would equal:
where e is the random error term. On average, it equals zero. e is also independent of P*.
Rational expectations theories were developed in response to perceived flaws in theories based on adaptive expectations. Under adaptive expectations, expectations of the future value of an economic variable are based on past values. For example, people would be assumed to predict inflation by looking at inflation last year and in previous years. Under adaptive expectations, if the economy suffers from constantly rising inflation rates (perhaps due to government policies), people would be assumed to always underestimate inflation. This may be regarded as unrealistic - surely rational individuals would sooner or later realise the trend and take it into account in forming their expectations? Further, models of adaptive expectations never attain equilibrium, instead only moving toward it asymtotically.
The hypothesis of rational expectations addresses this criticism by assuming that individuals take all available information into account in forming expectations. Though expectations may turn out incorrect, the deviations will not deviate systematically from the expected values.
The rational expectations hypothesis has been used to support some controversial conclusions for economic policymaking. For example, if the Central Bank decides to lower the unemployment rate by putting more money into the economy (an expansionary monetary policy), one interpretation of the rational expectations hypothesis (that of Robert Lucas) says that the policy will be ineffective. People will see what the Central Bank is doing and raise their expectations of future inflation. This in turn will counteract the expansionary effect of the increased money supply. All that the Central Bank can do is to raise the inflation rate, with at most temporary decreases in unemployment.
Rational expectations theory is the basis for the efficient market hypothesis and efficient markets theory. If a security's price does not reflect all the information about it, then there exist "unexploited profit opportunities": someone can buy (or sell the security) to make a profit, thus driving the price toward equilibrium. In the strongest versions of these theories, where all profit opportunities have been exploited, all prices in financial markets are correct and reflect market fundamentals (such as future profit streams). Each financial investment is as good as any other, while a security's price reflects all information about its intrinsic value.