What is the {term}? Rational Expectations Theory

The rational expectations theory is an economic concept whereby people make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in an economy are equivalent to what people think the future state of the economy will become. This contrasts with the idea that government policy influences people's decisions.

BREAKING DOWN Rational Expectations Theory

The rational expectations theory is often used to explain expected rates of inflation. For example, if inflation rates within an economy were higher than expected in the past, people consider this along with other indicators to assume that inflation may further increase in the future.

The rational expectations theory also explains how producers and suppliers use past events to predict future business operations. If a company believes that the price for its product will be higher in the future, for example, it will stop or slow production until the price rises. Since the company weakens supply while demand stays the same, the price will increase. The producer believes that the price will rise in the future and makes a rational decision to slow production, and this decision partially affects what happens in the future. By relying on the rational expectations theory, companies can inadvertently effect future inflation in an economy.

An Example of Rational Expectations Theory

Rational expectations theory, while valid, can sometimes have adverse effects on the global economy. For example, Former Bank of England governor Mervyn King noted that central banks could easily fall prey to the economy's rational expectations theory.

Since the theory stipulates that people in an economy make assumptions based largely on past experiences, specific monetary policies enacted by central banks can actually cause disequilibrium in an economy. When the Federal Reserve decided on a quantitative easing program to help the economy through the 2008 financial crisis, it set unattainable expectations for the country as outlined by the theory. The quantitative easing program reduced interest rates for more than seven years, and people began to believe that interest rates would remain low.

In 2015, when Janet Yellen announced that the Federal Reserve would increase interest rates starting in 2016, the markets reacted negatively because of the reliance on low interest rates. This rational expectations theory subsequently trapped the Federal Reserve into making decisions that would take expectations of the economy into account, and Yellen reneged on her initial decision to increase rates as many as four times in the subsequent years.