rational expectations theory

Examples of rational expectations theory in the following topics:

• Relationship Between Expectations and Inflation

  • There are two theories of expectations (adaptive or rational) that predict how people will react to inflation.
  • The theory of adaptive expectations states that individuals will form future expectations based on past events.
  • The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will be very close to the market equilibrium.
  • However, under rational expectations theory, workers are intelligent and fully aware of past and present economic variables and change their expectations accordingly.
  • In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically undermined by rational workers.

• Keynesian Theory

  • In economics, the Keynesian theory was first introduced by British economist John Maynard Keynes in his book The General Theory of Employment, Interest, and Money which was published in 1936 during the Great Depression .
  • According to the Keynesian theory, aggregate demand does not necessarily equal the productive capacity of the economy.
  • Although the beliefs of each school vary, all of the schools of economic thought have contributed to economic theory is some way.
  • In contrast, the Chicago School of economic thought focused price theory, rational expectations, and free market policies with little government intervention.
  • John Maynard Keynes introduced Keynesian theory in his book, The General Theory of Employment, Interest, and Money.

• Theory of Utility

  • The theory of utility states that, all else equal, a rational person will always choose the option that has the highest utility.
  • The theory of utility is based on the assumption of that individuals are rational.
  • Rationality has a different meaning in economics than it does in common parlance.
  • If, when everything is taken into account, one decision provides the greatest utility, which is equivalent to meaning that it is the most preferred, then we would expect the individual to take that most preferred option.
  • Based on their preferences, both made the economically rational choice.

• The Long-Run Phillips Curve

  • The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps.
  • The reason the short-run Phillips curve shifts is due to the changes in inflation expectations.
  • Workers, who are assumed to be completely rational and informed, will recognize their nominal wages have not kept pace with inflation increases (the movement from A to B), so their real wages have been decreased.
  • The NAIRU theory was used to explain the stagflation phenomenon of the 1970's, when the classic Phillips curve could not.
  • According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy.

• Assumptions

  • People have rational preferences among outcomes that can be identified and associated with a value.
  • An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding.
  • Later, the theory can be applied to more complex scenarios for additional study.
  • For example, economists assume that individuals are rational and maximize their utilities.
  • Examples of such assumptions include perfect information, profit maximization, and rational choices.

• Behavioral Economics: Irrational Actions

  • Behavioral economics focuses on the bounds of rationality of economic agents.
  • Behavioral game theory: analyzes interactive strategic decisions and behavior using the methods of game theory, experimental economics, and experimental psychology.
  • Market inefficiencies: include the study non-rational decision making and incorrect pricing.
  • This graph shows the three stages of rational decision making that was devised by Herbert Simon, a notable economist and scientist.

• The budget constraint: balancing income, consumption, and saving across time

  • Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices.
  • The theory of intertemporal choice is a response to the failure of Keynesian economics to predict consumption and savings patterns.
  • Fisher's model shows how rational forward looking consumers choose consumption for the present and future to maximize their lifetime satisfaction.
  • Foresight, self-control, habit, expectation of life, and or concern for the lives of others are the five personal factors that determine a person's impatience which in turn determines his time preference.
  • As a result is consumption is much higher than expected in the present, while saving is much lower.

• Which Methodology is "Correct?"

  • To understand and contribute to any field of knowledge, it is necessary to be aware of the methodology(ies) that have guided the development of accepted ideas, hypotheses, theories, concepts, tools, values and ideologies that are used within that discipline.
  • Methodological problems apply to all knowledge including Newtonian mechanics, the theory of relativity and quantum mechanics as well as economics.
  • Modern economic theory has a long tradition of following a "modernist" methodology characterized by a strong faith in empiricism and rationalism.
  • Within modern economics, knowledge is believed to be advanced by inductive or empirical investigations that can verify (or fail to falsify) "positive" concepts, hypothesis, theories or models developed by deductive or rationalist logic.

• Economic Decisions

  • Social expectations, customs, mores and traditions often inform individuals about rules of behavior.
  • Certain types of behavior are expected and influenced by such social constructs as "manners," mores, custom, rules of thumb and traditions.
  • At a technical level, economic analysis is used to evaluate rational decisions.
  • A rational choice requires that the alternative that "best" satisfies the objective be selected.
  • There are three fundamental steps to the process of making "rational" economic choices:

• How Stock Prices Are Determined

  • Investors are attracted to stocks of companies they expect will earn substantial profits in the future; because many people wish to buy stocks of such companies, prices of these stocks tend to rise.
  • For one thing, investors generally buy stocks according to their expectations about the unpredictable future, not according to current earnings.
  • Expectations can be influenced by a variety of factors, many of them not necessarily rational or justified.
  • Speculators often add to this upward pressure by purchasing shares in the expectation they will be able to sell them later to other buyers at even higher prices.