Difference perfect foresight and rational expectations
Answers
Rational expectations represent a theory in economics originally proposed by Muth (1961) and developed by Lucas, Phelps and Sargent to deal with expectations in economic models. At the time, expectations were largely ignored or modeled using simple backward-looking models such as adaptive expectations and distributed lag models. These old approaches were creating problems in economic analysis.
Backward-looking models of expectations suggested a constant rigidity in economic models that, in theory, allowed policymakers to systematically affect the macro economy and allowed speculators to make profits against naïve investors. In contrast, the basic idea of rational expectations is that agents need to be forward looking, and that it is rational to use all available information. As a result, the ideas of manipulating the economy and creating easy profit opportunities became much more difficult to support. To make the rational expectations theory operational several definitions exist, such as “no systematic forecast errors” or “consistent with the outcome of the economic model”. However, the validity of these particular definitions must be carefully examined; they tend to be based on specialized, extreme assumptions. Simple conclusions drawn from research based on these special assumptions can be misleading.
The perfect-foresight-with-error expectations model
The most frequently used model of rational expectations is the perfect-foresight-with-error model. This model is based on the assumptions that:
Economic agents are rational – goal oriented, make no systematic mistakes
All information is available and transparent, meaning:
- The economic model is known – i.e. effects of shocks can be calculated
- The type of shock hitting the economy is known – i.e. demand or supply, temporary or permanent
In mathematical notation we have then
Xet+1 = Et (Xt+1 | It)
Xet+1 = Xt+1 + et+1 Et (et+1) = 0 (no bias), Et (et+1 It) = 0 (no inefficiency of information use)
For theoretical economists who deal with a particular economic model, where the model is known and the shocks and variables are known, the correct rational expectations are easy to identify.
"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."
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