Ask Mint | Rational expectations: one factor no policymaker should ignore

Ask Mint | Rational expectations: one factor no policymaker should ignore

Our economy does not always move on dotted lines. Many a time, our economic policies fail to produce the intended results despite our best efforts. If we were to name one factor that could shatter any theory of economics, then most likely our first guess would be—people’s expectations.

After the pioneering works of economists such as John Muth and Robert E. Lucas, economic policymakers now realize that the expectations of countless number of people work just like winds. A favourable wind can make the task easier, but an unfavourable wind can shake even a sturdy boat. Economic policymakers need to keep a closer watch on rational expectations of people.

Johnny: Why just policymakers, even I am interested in understanding how rational expectations work. Can you elaborate a bit?

Jinny: The term rational expectations was first introduced by John Muth in 1961. However, it gained more prominence as a theory during the 1970s when Robert E. Lucas, who subsequently won a Nobel Prize, extended its application to different fields of macroeconomics. Macroeconomics, as you may be aware, deals with bigger economic issues such as economic growth, inflation, aggregate demand and supply, among others.

The hypothesis of rational expectations is simple: It states that people, by using all the information available currently, start making the best guess about the future, which often comes true. For instance, if people are expecting that higher fiscal deficits will lead to inflation, then in reality too that expectation is more likely to come true. Since these expectations are based on all the information currently available, and not merely on hunches or past experiences, we call them rational expectations. The word rational emphasizes that we are capable of using our collective minds to reach a reasonable prediction about the future in our own self-interest.

Rational expectations, therefore, play an important role in the economic decisions of individuals, households, firms and organizations. This is one factor no economic policymaker should ignore.

Also Read Shailaja and Manoj K. Singh’s earlier columns

Johnny: Can you explain how the rational expectations of people can influence an economic situation?

Jinny: The expectations of people have a tendency of becoming a self-fulfilling prophecy. For example, if people are expecting a higher inflation rate and higher demand for labour in the future, then that would have a strong effect on negotiation of future wages which, in turn, would itself have an effect on future inflation.

Illustration: Jayachandran / Mint

Likewise, many a time, expectations of devaluation of a currency could lead to actual devaluation if people start selling that currency based on expectations. Similarly, many other economic situations are connected with what we expect about the future.

The rational expectation theory implies that people are well versed in exploiting all available information to form their expectations. They constantly incorporate any newly available information which helps in either reinforcing or modifying existing expectations. The successes or failures of many economic policies depend upon how expectations are changing.

Johnny: How can rational expectations affect economic policies?

Jinny: To understand this, let’s take an example of monetary policy. It is widely believed that we can’t fight inflation or take care of recession merely by using the standard tools of monetary policy. Many a time, interest rates or money supply could fail to steer the economy in the right directions if peoples’ expectations are not in favour. A lower interest rate, instead of reviving economic growth can very well lead to inflation, a situation which is known as stagflation. A central bank is more effective if its policies gain credibility.

So while formulating any change in economic policies—be it a new monetary policy, a new fiscal policy or a new exchange rate policy—it would be worthwhile if the effect of the new policy on peoples’ expectations is taken into account. A shift in peoples’ expectations could lead to a different outcome.

Johnny: That sounds convincing, but can you now also highlight the main drawbacks in the theory of rational expectations?

Jinny: Well, the major flaw in this theory is that it presumes more than it explains. People are neither perfectly rational nor perfectly informed. Some of the key information is available only to a select few.

Moreover, getting some information may involve some cost, which everybody can’t afford. That’s why different people will have different expectations.

The theory of rational expectations would work perfectly well if we presume that all information is freely available and everybody is equally capable of using the available information. But in reality, that hardly seems to be the case. Different individuals stand on different footing.

However, we should not forget that the theory of rational expectations takes a macro view. It looks at things from a higher perspective by taking into account the aggregate view—a sum total of the different expectations of different people—which ultimately represents one single picture. It is just like looking at a forest from a helicopter—all trees look the same.

Johnny: Thanks for explaining all this, Jinny. To successfully navigate the forest of economic theories, we sometimes need to look at the big picture.