\nThe rational expectations theory is the dominant assumption model used in business cycles and finance as a cornerstone of the efficient market hypothesis<\/a> (EMH).<\/p>\n
Economists often use the doctrine of rational expectations to explain anticipated\u00a0inflation<\/a> rates or any other economic state. For example, if past inflation rates were higher than expected, then people might consider this, along with other indicators, to mean that future inflation also might exceed expectations.<\/p>\n
The actual theory of rational expectations was proposed by John F. Muth in his seminal paper, \u201cRational Expectations and the Theory of Price Movements,\u201d published in 1961 in the journal, Econometrica<\/em>. Muth used the term to describe numerous scenarios in which an outcome depends partly on what people expect will happen. The theory did not catch on until the 1970s with\u00a0Robert E. Lucas, Jr<\/a>. and the\u00a0neoclassical<\/a>\u00a0revolution in economics.<\/p>\n<\/blockquote>\n<\/div>\n<\/div>\n<\/article>\n<\/div>\n
As explanation they offered this:<\/p>\n
\nThis doctrine is motivated by the thinking that led Abraham Lincoln to assert, \u201cYou 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.\u201d<\/p>\n
From the perspective of rational expectations theory, Lincoln\u2019s statement is on target: The theory does not deny that people often make forecasting errors, but it does suggest that errors will not recur persistently.<\/p>\n
Because people make decisions based on the available information at hand combined with their past experiences, most of the time their decisions will be correct. If their decisions are correct, then the same expectations for the future will occur. If their decision was incorrect, then they will adjust their behavior based on the past mistake.<\/p>\n<\/blockquote>\n<\/div>\n<\/div>\n
This is a logic I cannot agree with. It is all too obvious that, firstly, people are not rational; second that people view data and experience through personal perspectives, and that some are attributed undue weighting in this process meaning that collective views are rarely collective; third, that people are not independent of each other when exercising judgement and that therefore crowds can be wrong and, fourth, that outside views, even when right, are routinely dismissed as irrational because they are not the norm. I am well aware that it is claimed that behavioural economics addresses these issues. In my opinion, polishing a theory that is wrong does not make it right.<\/div>\n<\/div>\n<\/div>\n
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