Rational Expectation

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RATIONAL EXPECTATION

While rational expectations is often thought of as a school of economic thought, it is better regarded as a ubiquitous modeling technique used widely throughout economics.
The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. He used the term to describe the many economic situations in which the outcome depends partly on what people expect to happen. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price farmers expect to realize when they harvest and sell their crops. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock or bond depends partly on what prospective buyers and sellers believe it will be in the future.

Expectational Error Models of the Business Cycle
A long tradition in business cycle theory has held that errors in people’s forecasts are a major cause of business fluctuations. This view is embodied in the phillips curve (the observed inverse correlation between unemployment and inflation), with economists attributing the correlation to errors people make in their forecasts of the price level. Before the advent of rational expectations, economists often proposed to “exploit” or “manipulate” the public’s forecasting errors in ways designed to generate better performance of the economy over the business cycle. Thus, Robert Hall aptly described

In economics, shock therapy refers to the sudden release of price and currency controls, withdrawal of state subsidies, and immediate trade liberalization within a country, usually also including large scale…...

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