Rational expectations

Updated: Aug 20, 2021

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.

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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.