<blockquote>
  <p>The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be. The concept is motivated by the same thinking that led Abraham Lincoln to assert, “You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” From the viewpoint of the rational expectations doctrine, Lincoln’s statement gets things right. It does not deny that people often make forecasting errors, but it does suggest that errors will not persistently occur on one side or the other.</p>
</blockquote>

<p>from Tomas Sargent (<a href="https://www.econlib.org/library/Enc/RationalExpectations.html" rel="nofollow noreferrer">https://www.econlib.org/library/Enc/RationalExpectations.html</a>)</p>

CC BY-SA 4.0
2018-09-07T21:24:08.163Z
Hi: I've read a lot about RE and my belief is that one can only understand it with respect to its econometric implications. There are so many discussions but possibly the best one I've seen is 171-179 of the paper "on econometric models with rational expecations" by broze and szafarz. of course, you can read the whole thing but those first 8 pages are really good. If you can't obtain it, let me know and I can scan it and send it to your email address. Pesaran's text is the best full book discussion of it that I know of. – mark leeds 2 hours ago
mark leeds
CC BY-SA 4.0
2018-09-07T14:49:48.803Z
2018-09-07T14:49:48.803Z
chatGPT
<p>Rational Expectations - as opposed to Adaptive Expectations - is a theoretical framework in which agents form expectations not solely based on past experiences but also on current information, priors and what they think is going to happen.</p>

<p>It doesn't imply perfect prediction of the future, just that a policymaker can't systematically fool agents, at the risk of losing credibility. This was a big leap forward in terms of macroeconomic theory in the 70s.</p>

<p>EDIT: Mark's comment reminded me of an important aspect of RE. Before it, models assumed agents <em>didn't know the model</em>. Part of the Lucas Critique is that policymakers can't statically estimate parameters and think that agents aren't responsive to policy trying to explore trade-offs and induce certain states.</p>

CC BY-SA 4.0
2018-09-08T21:04:00.343Z
Pedro: There are so many definitions so I'm not saying you are wrong but, I'll give a different definition here.  From an econometric perspective, RE says that the agent ( say the farmer being modelled in a wheat demand model ) has the same model as the econometrician so his expectations are the same as those in the model itself.  It's a really interesting viewpoint ( it's origins are in the Muth, 1961 paper )  and some say too strong of an assumption.
mark leeds
CC BY-SA 4.0
2018-09-08T23:41:08.050Z
I've just added this (very relevant) point. Thanks, Mark.
Pedro Cavalcante
CC BY-SA 4.0
2018-09-09T01:30:01.087Z
Pedro: your welcome and good to meet you.
mark leeds
CC BY-SA 4.0
2018-09-08T20:48:02.923Z
2018-09-08T23:39:46.663Z
2018-09-08T23:39:46.663Z
Pedro Cavalcante
<p>I will provide an actual answer because I strongly believe that embedding the rational expectations (RE) assumption into macroeconomic models is ridiculous. </p>

<p>I will try to crystalize this in a concise way. Anytime we try to use a macroeconomic model to forecast outcomes we are actually creating a model that incorporates, via probability distribution, all possible outcomes. RE assumes that nothing unforeseen occurs (it is whenever nothing unforeseen occurs that rational agents can act optimally) and that rational agents are then able to compute profit maximizing choice paths. Further, any behavioral deviations necessarily produce sub-optimal paths for choice variables. This is akin to assuming that all economic actors know the model governing the DGP within which they operate. And this yields (2): agents can only form RE whenever they know the true specification of the economic model governing their world and its exact parameterization. You decide for yourself if you think these are good assumptions. </p>

<p>This yields an extreme (and perhaps dangerous) system of thinking; the supposition that economic models ought to consistently provide reliable quantitative predictions about future outcomes, for example. It is also ironic that modern macroeconomists micro-found current models to attain quantitative predictions over an ordinal outcome. </p>

<p>See the work of Roman Frydman. A good starting point is "Towards an Understanding of Market Processes: Individual Expectations, Learning, and Convergence to Rational Expectations Equilibrium". AER, 1982. </p>

<p>You might also look into the behavioral and experimental macroeconomics literature. </p>

<p>edit: I will add --  Evans, G. W. and G. Ramey (2006) Adaptive Expectations, Under parameterization and the Lucas Critique. Journal of Monetary Economics for assertion (2)</p>

<p>edit2: My memory was incorrect and erik (below in comments) is correct. Frydman didn't win the NP. It was his co-founder of his institution at Columbia university Edmund Phelps. </p>

CC BY-SA 4.0
2018-09-09T18:59:04.683Z
RE isn't assuming "nothing unforeseen occurs". Good god, read the Lucas Critique. You're attacking a strawman.
Pedro Cavalcante
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2018-09-09T19:03:25.837Z
I have definitely read that work. You are obviously the one who is out of touch with literature. You come across as someone without a PhD who was browbeaten with RE and is now a full-on disciple regurgitating the arguments of others. And you keep saying straw man as though you've provided a more accurate definition of RE than the one I take from Frydman, Heckman, and others. In fact, you've provided a definition of RE where RE gets to be anything other than fully-adaptive behavior.
123
CC BY-SA 4.0
2018-09-09T19:05:01.990Z
This isn't my area (I work with education and labor), but it doesn't take much to realise you're attacking a strawman. Please, name _one_ economist who thinks "nothing unforseen occurs".
Pedro Cavalcante
CC BY-SA 4.0
2018-09-09T19:10:44.283Z
P.S.: The funny thing I don't even agree with RE. I much rather prefer Gabaix's approach of bounded rationality and intertemporal myopia, which uses many insights from behavioral econ.
Pedro Cavalcante
CC BY-SA 4.0
2018-09-09T19:12:41.127Z
The hilarity of your rebuttal is that  I cited the nobel laureate whose argument I paraphrase and included a link to the (his) relevant AER publication. And trust me...it is very clear to me that this is not your area. And because I think it is funny, how about I also cite Evans and Ramey's 2006 JME paper that specifically addresses the Lucas Critique in the context of RE and AE.
123
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2018-09-10T04:28:36.080Z
I'm not going to take sides here but have been reading about RE for about 2-3 years on and off. The only example in the literature that  I was actually able to follow the gory details of  was the RE example of Lucas in his "natural rate hypothesis" ( 1972 ) paper. Anyway, I was able to back out the equations in that paper ( with the help of Alecos ) so if either of you want to explain what is right or wrong with that paper's argument, I'm all ears. No rush of course. Thanks to both of you for your comments. Also thanks to 123 for references. I will check those out for sure.
mark leeds
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2018-09-10T04:32:19.257Z
Also, if you either of you know why the authors of econometric RE publications write in such a way that only the crew of mcallum, taylor, sims, pesaran,, sargent, wallis, hansen, wallace, lucas and a few others can follow them, I'd love to know. Wouldn't they want to spread the word by making their work more readable ? Often nothing is even defined ? Somehow I was able to understand Lucas paper but that was a miracle and maybe specific to Lucas because I haven't tried to read a lot of his material. Maybe a lot of his material is readable ?
mark leeds
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2018-09-10T06:42:42.300Z
@123: The Frydman paper looks very educational at a glance. It's odd because I've either seen or have almost every reference in that Frydman paper but I've never seen that paper referenced in the literature nor have I heard of Frydman.  And I have read A LOT of the RE literature.  But he's a nobel laureate so that must be me not reading as much as I think I've read.!!!!!  I'll read the other one also but I need to know RE cold before I take on learning. I know the second will be more difficult because have some of Evans stuff  and it's not easy. Thanks a lot for both references.
mark leeds
CC BY-SA 4.0
2018-09-10T10:05:12.703Z
@markleeds: Roman Frydman is not a Nobel laureate. Though of course I agree, that status neither validates or invalidates what he has to say.
erik
CC BY-SA 4.0
2018-09-10T13:22:53.843Z
Erik: Thanks. 123 said he was one and I'm not up on all of them so I just assumed he was. Still, his paper looks interesting and I recommend it.
mark leeds
CC BY-SA 4.0
2018-09-11T02:35:47.460Z
@erik -- you are correct ... I was thinking of his partner Edmund Phelps. Thanks for the correction.
123
CC BY-SA 4.0
2018-09-11T05:04:31.033Z
Pedro and 123: The Lucas Natural Rate Hypothesis paper is not easy to obtain so, if either of you want it, let me know and I can scan and send it to you in email. Of course, then I need your email addresses. If not interested, that's fine. I was just ecstatic to be able to derive the equations-results in that RE paper since most of them are all quite confusing. All the best.
mark leeds
CC BY-SA 4.0
2018-09-09T18:34:03.677Z
2018-09-11T02:34:49.820Z
2018-09-11T02:34:49.820Z
123
<p>The concept of rational expectations can indeed be confusing. </p>

<p>One of the nicest pieces that I read online on rational expectations is the following: </p>

<p><a href="https://economictheoryblog.com/2012/05/18/rational-expectations" rel="nofollow noreferrer">https://economictheoryblog.com/2012/05/18/rational-expectations</a></p>

<p>It very nicely describes the concept of rational expectations in very simple words. </p>

<p>The most important thing one needs to understand is that rational expectations do not imply that all people act optimal under all circumstances, it rather implies that people behave optimally given the information they have. </p>

CC BY-SA 4.0
2018-09-10T19:37:30.250Z
Hi Gio: It is a clear article. But, to be honest, from an econometric perspective, it is  mis-leading because it says that, in RE, economic agents can have limited information or whatever information you assume them to have. This is not really true. Suppose one has a model that says tomato prices are AR(1). Then RE assumes that the farmer of tomatoes also believes that  tomatoe prices are AR(1). That might be viewed as limited but for the article to say that the information of the economic agent can be limited could be mis-leading since he has the same info as the modeler. Thanks for link.
mark leeds
CC BY-SA 4.0
2018-09-10T18:18:19.090Z
2018-09-10T18:18:19.090Z
Gio Pellegrino
<p>I am struggling understanding the concept of rational expectations. Can someone explain in simple words the concept of rational expectations? Does someone know a good (online) source explaining rational expectations?</p>

CC BY-SA 4.0
2018-09-07T14:53:48.590Z
Just know that it is a terrible assumption. Economists have shown in experiments over and over and over that RE does not hold. People deviate systematically from rationality. The representative agent assumption is equally stupid.
123
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2018-09-08T20:55:10.907Z
Ok, this guy 123 is _wrong_. Assuming rationality is one thing, modeling agents in macroeconomic models with rational expectations is an entirely different thing.

[Cochrane's take on the matter](https://johnhcochrane.blogspot.com/2015/05/homo-economicus-or-homo-paleas.html) is a good read.
Pedro Cavalcante
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2018-09-09T01:23:51.990Z
Pedro: Very interesting link. Thanks for pointing it out.
mark leeds
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2018-09-09T17:51:39.423Z
@PedroCavalcanteOliveira  -- I am definitely not wrong about the fact that outcomes deviate systematically and consistently from people's expectations. Again, experimental and behavioral economists have shown this over and over in the lab and in the field. People are adaptive. This is the entire reason that we see people (for example, XG at Harvard) building behavioral macro models. This is why we now discuss e-stability. This is why the work of Arifovic is so important. This is why the work of Duffy is so important. So unless you define RE differently than above, you are misleadingly wrong.
123
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2018-09-09T18:26:40.810Z
Rational Expectations isn't assuming people correctly predict the future, just that they don't see what happened today, what they thought would happen tomorrow and change expectations adaptively. People use all sorts of information during expectations formations - _that's_ what Rational Expectations is about, not that people have superpowers.
Pedro Cavalcante
CC BY-SA 4.0
2018-09-09T18:28:38.640Z
And I'm not even mentioning the econometric implications of RE. You _are_ wrong, your entire conception of RE is basically a strawman. Not only that, you're also confusing what assuming rationality in a microeconomic modelling context with Rational Expectations.
Pedro Cavalcante
CC BY-SA 4.0
2018-09-09T18:36:58.150Z
@PedroCavalcanteOliveira -- "that they don't see what happened today, what they thought would happen tomorrow and change expectations adaptively...". How do you square this argument then with the multitude of literature produced within behavioral/experimental macroeconomics that consistently replicates the finding that humans are adaptive? Not only are you wrong, you are  VERY CLEARLY ignorant of the research in this area.
123
CC BY-SA 4.0
2018-09-09T18:44:26.807Z
Adaptive expectations are one in which the expectation formation process follows a specific pattern - one any undergrad studies in intermediary macro when studying the Phillips` Curve. 

If people do indeed form their expectations like that, then Central Banks would be able to systematically exploit the short-run trade-off between inflation and unemployment. Which of course they can`t. Check out Gabaix`s work in behavioral NK models. One can think of bounded rationality as "short-run Rational Expectations".
Pedro Cavalcante
CC BY-SA 4.0
2018-09-09T18:54:02.490Z
@PedroCavalcanteOliveira -- nothing you've said can refute the fact that people are demonstrably adaptive and that this fact has been replicated ad nauseam. You sound like someone with no knowledge of literature.
123
CC BY-SA 4.0
2018-09-09T18:56:45.530Z
The point isn't that people do weird things, it's that you think RE is something it simply isn't. You think RE is saying people predict the future or have high cognitive skills, but it isn't, it is _simply_ the assumption that people don't take solely information about the past to form expectations. Systematically wrong forecasting is fully compatible with RE :).
Pedro Cavalcante
<macroeconomics><microeconomics>
Explanation Rational Expectations
Sam Itly
# Explanation Rational Expectations

(Asked by: username_0 on 2018-09-07)

I am struggling understanding the concept of rational expectations. Can someone explain in simple words the concept of rational expectations? Does someone know a good (online) source explaining rational expectations?

**Tags:** macroeconomics, microeconomics

> **Comments:**
> **username_1**: Just know that it is a terrible assumption. Economists have shown in experiments over and over and over that RE does not hold. People deviate systematically from rationality. The representative agent assumption is equally stupid.  
> **username_2**: Ok, this guy username_1 is _wrong_. Assuming rationality is one thing, modeling agents in macroeconomic models with rational expectations is an entirely different thing.  [Cochrane's take on the matter](https://johnhcochrane.blogspot.com/2015/05/homo-economicus-or-homo-paleas.html) is a good read.  
> **username_3**: Pedro: Very interesting link. Thanks for pointing it out.  
> **username_1**: @PedroCavalcanteOliveira  -- I am definitely not wrong about the fact that outcomes deviate systematically and consistently from people's expectations. Again, experimental and behavioral economists have shown this over and over in the lab and in the field. People are adaptive. This is the entire reason that we see people (for example, XG at Harvard) building behavioral macro models. This is why we now discuss e-stability. This is why the work of Arifovic is so important. This is why the work of Duffy is so important. So unless you define RE differently than above, you are misleadingly wrong.  
> **username_2**: Rational Expectations isn't assuming people correctly predict the future, just that they don't see what happened today, what they thought would happen tomorrow and change expectations adaptively. People use all sorts of information during expectations formations - _that's_ what Rational Expectations is about, not that people have superpowers.  
> **username_2**: And I'm not even mentioning the econometric implications of RE. You _are_ wrong, your entire conception of RE is basically a strawman. Not only that, you're also confusing what assuming rationality in a microeconomic modelling context with Rational Expectations.  
> **username_1**: @PedroCavalcanteOliveira -- "that they don't see what happened today, what they thought would happen tomorrow and change expectations adaptively...". How do you square this argument then with the multitude of literature produced within behavioral/experimental macroeconomics that consistently replicates the finding that humans are adaptive? Not only are you wrong, you are  VERY CLEARLY ignorant of the research in this area.  
> **username_2**: Adaptive expectations are one in which the expectation formation process follows a specific pattern - one any undergrad studies in intermediary macro when studying the Phillips` Curve.   If people do indeed form their expectations like that, then Central Banks would be able to systematically exploit the short-run trade-off between inflation and unemployment. Which of course they can`t. Check out Gabaix`s work in behavioral NK models. One can think of bounded rationality as "short-run Rational Expectations".  
> **username_1**: @PedroCavalcanteOliveira -- nothing you've said can refute the fact that people are demonstrably adaptive and that this fact has been replicated ad nauseam. You sound like someone with no knowledge of literature.  
> **username_2**: The point isn't that people do weird things, it's that you think RE is something it simply isn't. You think RE is saying people predict the future or have high cognitive skills, but it isn't, it is _simply_ the assumption that people don't take solely information about the past to form expectations. Systematically wrong forecasting is fully compatible with RE :).  

---

## 4 answers

### Answer by username_6 on 2018-09-10. Score: 4 | Accepted answer

The concept of rational expectations can indeed be confusing.

One of the nicest pieces that I read online on rational expectations is the following:

<https://economictheoryblog.com/2012/05/18/rational-expectations>

It very nicely describes the concept of rational expectations in very simple words.

The most important thing one needs to understand is that rational expectations do not imply that all people act optimal under all circumstances, it rather implies that people behave optimally given the information they have.

> **Comments:**
> **username_3**: Hi Gio: It is a clear article. But, to be honest, from an econometric perspective, it is  mis-leading because it says that, in RE, economic agents can have limited information or whatever information you assume them to have. This is not really true. Suppose one has a model that says tomato prices are AR(1). Then RE assumes that the farmer of tomatoes also believes that  tomatoe prices are AR(1). That might be viewed as limited but for the article to say that the information of the economic agent can be limited could be mis-leading since he has the same info as the modeler. Thanks for link.  

---

### Answer by username_4 on 2018-09-07. Score: 3

> The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be. The concept is motivated by the same thinking that led Abraham Lincoln to assert, “You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” From the viewpoint of the rational expectations doctrine, Lincoln’s statement gets things right. It does not deny that people often make forecasting errors, but it does suggest that errors will not persistently occur on one side or the other.

from Tomas Sargent (<https://www.econlib.org/library/Enc/RationalExpectations.html>)

> **Comments:**
> **username_3**: Hi: I've read a lot about RE and my belief is that one can only understand it with respect to its econometric implications. There are so many discussions but possibly the best one I've seen is 171-179 of the paper "on econometric models with rational expecations" by broze and szafarz. of course, you can read the whole thing but those first 8 pages are really good. If you can't obtain it, let me know and I can scan it and send it to your email address. Pesaran's text is the best full book discussion of it that I know of. – username_3 2 hours ago  

---

### Answer by username_2 on 2018-09-08. Score: 1

Rational Expectations - as opposed to Adaptive Expectations - is a theoretical framework in which agents form expectations not solely based on past experiences but also on current information, priors and what they think is going to happen.

It doesn't imply perfect prediction of the future, just that a policymaker can't systematically fool agents, at the risk of losing credibility. This was a big leap forward in terms of macroeconomic theory in the 70s.

EDIT: Mark's comment reminded me of an important aspect of RE. Before it, models assumed agents *didn't know the model*. Part of the Lucas Critique is that policymakers can't statically estimate parameters and think that agents aren't responsive to policy trying to explore trade-offs and induce certain states.

> **Comments:**
> **username_3**: Pedro: There are so many definitions so I'm not saying you are wrong but, I'll give a different definition here.  From an econometric perspective, RE says that the agent ( say the farmer being modelled in a wheat demand model ) has the same model as the econometrician so his expectations are the same as those in the model itself.  It's a really interesting viewpoint ( it's origins are in the Muth, 1961 paper )  and some say too strong of an assumption.  
> **username_2**: I've just added this (very relevant) point. Thanks, Mark.  
> **username_3**: Pedro: your welcome and good to meet you.  

---

### Answer by username_1 on 2018-09-09. Score: -1

I will provide an actual answer because I strongly believe that embedding the rational expectations (RE) assumption into macroeconomic models is ridiculous.

I will try to crystalize this in a concise way. Anytime we try to use a macroeconomic model to forecast outcomes we are actually creating a model that incorporates, via probability distribution, all possible outcomes. RE assumes that nothing unforeseen occurs (it is whenever nothing unforeseen occurs that rational agents can act optimally) and that rational agents are then able to compute profit maximizing choice paths. Further, any behavioral deviations necessarily produce sub-optimal paths for choice variables. This is akin to assuming that all economic actors know the model governing the DGP within which they operate. And this yields (2): agents can only form RE whenever they know the true specification of the economic model governing their world and its exact parameterization. You decide for yourself if you think these are good assumptions.

This yields an extreme (and perhaps dangerous) system of thinking; the supposition that economic models ought to consistently provide reliable quantitative predictions about future outcomes, for example. It is also ironic that modern macroeconomists micro-found current models to attain quantitative predictions over an ordinal outcome.

See the work of Roman Frydman. A good starting point is "Towards an Understanding of Market Processes: Individual Expectations, Learning, and Convergence to Rational Expectations Equilibrium". AER, 1982.

You might also look into the behavioral and experimental macroeconomics literature.

edit: I will add -- Evans, G. W. and G. Ramey (2006) Adaptive Expectations, Under parameterization and the Lucas Critique. Journal of Monetary Economics for assertion (2)

edit2: My memory was incorrect and username_5 (below in comments) is correct. Frydman didn't win the NP. It was his co-founder of his institution at Columbia university Edmund Phelps.

> **Comments:**
> **username_2**: RE isn't assuming "nothing unforeseen occurs". Good god, read the Lucas Critique. You're attacking a strawman.  
> **username_1**: I have definitely read that work. You are obviously the one who is out of touch with literature. You come across as someone without a PhD who was browbeaten with RE and is now a full-on disciple regurgitating the arguments of others. And you keep saying straw man as though you've provided a more accurate definition of RE than the one I take from Frydman, Heckman, and others. In fact, you've provided a definition of RE where RE gets to be anything other than fully-adaptive behavior.  
> **username_2**: This isn't my area (I work with education and labor), but it doesn't take much to realise you're attacking a strawman. Please, name _one_ economist who thinks "nothing unforseen occurs".  
> **username_2**: P.S.: The funny thing I don't even agree with RE. I much rather prefer Gabaix's approach of bounded rationality and intertemporal myopia, which uses many insights from behavioral econ.  
> **username_1**: The hilarity of your rebuttal is that  I cited the nobel laureate whose argument I paraphrase and included a link to the (his) relevant AER publication. And trust me...it is very clear to me that this is not your area. And because I think it is funny, how about I also cite Evans and Ramey's 2006 JME paper that specifically addresses the Lucas Critique in the context of RE and AE.  
> **username_3**: I'm not going to take sides here but have been reading about RE for about 2-3 years on and off. The only example in the literature that  I was actually able to follow the gory details of  was the RE example of Lucas in his "natural rate hypothesis" ( 1972 ) paper. Anyway, I was able to back out the equations in that paper ( with the help of Alecos ) so if either of you want to explain what is right or wrong with that paper's argument, I'm all ears. No rush of course. Thanks to both of you for your comments. Also thanks to username_1 for references. I will check those out for sure.  
> **username_3**: Also, if you either of you know why the authors of econometric RE publications write in such a way that only the crew of mcallum, taylor, sims, pesaran,, sargent, wallis, hansen, wallace, lucas and a few others can follow them, I'd love to know. Wouldn't they want to spread the word by making their work more readable ? Often nothing is even defined ? Somehow I was able to understand Lucas paper but that was a miracle and maybe specific to Lucas because I haven't tried to read a lot of his material. Maybe a lot of his material is readable ?  
> **username_3**: @username_1: The Frydman paper looks very educational at a glance. It's odd because I've either seen or have almost every reference in that Frydman paper but I've never seen that paper referenced in the literature nor have I heard of Frydman.  And I have read A LOT of the RE literature.  But he's a nobel laureate so that must be me not reading as much as I think I've read.!!!!!  I'll read the other one also but I need to know RE cold before I take on learning. I know the second will be more difficult because have some of Evans stuff  and it's not easy. Thanks a lot for both references.  
> **username_5**: @markleeds: Roman Frydman is not a Nobel laureate. Though of course I agree, that status neither validates or invalidates what he has to say.  
> **username_3**: Erik: Thanks. username_1 said he was one and I'm not up on all of them so I just assumed he was. Still, his paper looks interesting and I recommend it.  
> **username_1**: @username_5 -- you are correct ... I was thinking of his partner Edmund Phelps. Thanks for the correction.  
> **username_3**: Pedro and username_1: The Lucas Natural Rate Hypothesis paper is not easy to obtain so, if either of you want it, let me know and I can scan and send it to you in email. Of course, then I need your email addresses. If not interested, that's fine. I was just ecstatic to be able to derive the equations-results in that RE paper since most of them are all quite confusing. All the best.  

---

