Money, Banking, and Financial Markets Practice Test: Rational Expectations — Flashcards

Rational expectations is an economic theory that attempts to infer the macroeconomic consequences of people's decisions based on all available knowledge. It's a modeling technique used in economics to describe economic situations where the outcome depends on what people expect to happen. 

The theory assumes that there is a commonly accepted economic theoretical model that captures the evolution of the economy. At an equilibrium, people should form their expectations consistently with that model. 
The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. The term first appeared in an economic journal article in 1961. 
Rational expectations challenges traditional beliefs about how the economy works. It argues that existing economic models and theories fail to capture the true responsiveness of real-life decision makers to government policy actions. 

Some applications of rational expectations include:
Efficient markets theory of stock prices: This theory uses rational expectations to conclude that stock price changes follow a random walk.
New classical school of economics: New classical economists believe that fiscal and monetary policies will not work if they are anticipated.
 

Related Test: Money, Banking, and Financial Markets Practice Test: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis