Is The “rational Expectations Hypothesis” Dead?
by Rational expectations theory has been the pillar on which most economic research is undertaken. It it the concept that has reduced human behaviour to mathematical equations and statistical figures. However, the inability of this theory to explain business cycles and especially the asset market fluctuations had discredited it in an irreversible manner.
Rational Expectations theory is perhaps that one single concept that has changed the way economic research is undertaken. Ever since Muth came up with his famous articulation of the rational expectations theory, the world of economics has never been the same.
Muth’s Rational economic agents
Muth conceived people as rational economic agents, who act to maximize their own utility, and their expectations actually reflect the equilibrium status achieved by the economy. In his words, “I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. At the risk of confusing this purely descriptive hypothesis with a pronouncement as to what firms ought to do, we call such expectations rational.”
What Muth effectively said was that the expectations of the masses are always coincidental with the market equilibrium, and so they can never be irrational. This has huge implications, because if expectations are always coincidental with the market forces of supply and demand, then markets as well as expectations are never irrational and hence unlikely to fail.
Lucas & others refined the theory
Subsequently, major development of Muth’s hypothesis was undertaken by Lucas (1972), who applied the concept to expected monetary expectation. The role of expectations was then combined with the concept of ‘equilibrium’ which had been introduced prior to the work of Muth by Arrow and Debreu (1954) who showed equilibriums to form in competitive economy. The rational expectations hypothesis assumes that people as rational agents have expectations that are consistent with the stable equilibrium. One can add to say here that as per this hypothesis, any variation (error) of such expectations from the equilibrium state is immediately taken note of by other agents, who rush to cash on the arbitrage opportunity in such a way that such errors are immediately corrected, without any significant lags, and with insignificant costs.
The greatest impact of ‘rational expectations theory’ was on the way economic research was conducted. It laid the foundation for taking the human behaviour as that of a machine, that can be expressed in mathematical terms – a phenomenon that allowed the growth of multiple regression and econometric analysis as the most favoured method of empirical research and simple, often linear mathematical equations with multiple simplistic assumptions as the most favoured way of theoretical analysis of human economic behaviour.
The role of expectations
Long before Muth, Alfred Marshall (1879) had suggested a relationship of expectations with business cycles. To a large extent, during the half a century of our experience with rational expectation theory, this theory has spectacularly failed to explain business cycles. In spite of this, it continued to be the most favoured economy among the economic community for one simple reason – it provided great convenience to economic researchers by allowing them to convert all human behaviour to mathematical and statistical equations and figures. The use of statistics and figures, often base of innumerable assumptions in addition to the rational expectations theory, created an illusion of evidence that was actually little more than self-hypnotic in nature, and often enabled the economists to claim that economics was more of a basic science than a social one.
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Post CommentKristie Claar
On October 8, 2011 at 1:28 pm
well written article