Rational expectations

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock… read more.

Updated: Aug 20, 2021

Ad disclosure

Invezz is an independent platform with the goal of helping users achieve financial freedom. In order to fund our work, we partner with advertisers who compensate us for users that Invezz refers to their services. While our reviews and assessments of each product on the site are independent and unbiased, brands may pay to appear higher up our table rankings or place ads in specific areas of the site. The order in which products and services appear on Invezz does not represent an endorsement from us, and please be aware that there may be other platforms available to you than the products and services that appear on our website. Read more about how we make money >

A decision-taker is said to form rational expectations when he uses available knowledge and information so as not to make systematic errors. As an example of expectations which are not rational, take the case of the market involved in the cobweb theorem. Here suppliers expect that this period’s price will continue to prevail in the next period, despite the fact that in every period they are proved wrong. An economist who knew the cobweb theorem could make an impressive profit as a speculator in such a market. Such false expectations cannot persist if there is a profit to be made out of forming correct expectations. The usual assumption of rationality in economics therefore suggests that expectations which are systematically wrong will be revised, so that in the end expectations will be formed which are on average correct. That is, errors will be randomly distributed about the correct value.

Reference: The Penguin Business Dictionary, 3rd edt.