Definition and contrast with adaptive expectations
John Muth (1961) assumed that firms' price expectations are "essentially the same as the predictions of the relevant economic theory" and called them "rational expectations": the average of people's subjective expectations matches the objective forecast of the model. Before that, "adaptive expectations," used by Cagan (1956) and others, were standard: people gradually correct past forecast errors, so when inflation keeps rising they are wrong in the same direction every time. Rational expectations rule out such systematic errors. The point is less that every individual is perfect than that, in equilibrium, people do not keep repeating predictable mistakes, which can be seen as applying rational choice theory to expectation formation.
The rational expectations revolution in macroeconomics
In the 1970s, Robert Lucas (1972) brought rational expectations into macroeconomic models and found that only unanticipated monetary shocks affect output, and only temporarily. Sargent and Wallace (1976) put forward the "policy ineffectiveness proposition" that systematic, predictable monetary policy cannot affect real variables, shaking faith in fine-tuning via the Phillips curve. Together with the Lucas critique, these ideas transformed macroeconomic methodology. Taylor (1980) and others showed, however, that with staggered wage and price setting, monetary policy can have real effects even under rational expectations, a foundation of today's New Keynesian models (see Keynesian economics). In finance, Fama's (1970) efficient market hypothesis held by similar logic that prices reflect available information, while Grossman and Stiglitz (1980) pointed out the paradox that fully efficient markets are impossible if gathering information is costly.
Critiques and alternatives
Critics argue that rational expectations assume, implausibly, that people know the entire model. Sargent (1993) himself called for bringing bounded rationality and learning into macroeconomics, and Evans and Honkapohja (2001) analyzed when statistical learning converges to rational expectations equilibria. Mankiw and Reis (2002) proposed "sticky information" updated only slowly, and Sims (2003) proposed "rational inattention," in which limited attention leads people to process information selectively. Coibion and Gorodnichenko (2015) showed in professional forecaster surveys that forecast errors are predictable from past revisions, evidence of information rigidity, and Gabaix (2020) proposed a behavioral New Keynesian model in which agents discount the future myopically. Even so, rational expectations remain the benchmark starting point for policy analysis.
FAQ
- Do rational expectations mean people always forecast correctly?
- No. Forecasts can often be wrong, but the errors average zero and contain no systematic pattern that available information could have predicted.
- How do adaptive and rational expectations differ?
- Adaptive expectations adjust only on past values and past errors, while rational expectations incorporate new information, such as a policy change, and reflect the structure of the economy.
Sources reviewed: 2026-10-26
References
- Muth, J. F. (1961). Rational expectations and the theory of price movements. Econometrica, 29(3), 315–335.
- Cagan, P. (1956). The monetary dynamics of hyperinflation. In M. Friedman (Ed.), Studies in the Quantity Theory of Money (pp. 25–117). Chicago: University of Chicago Press.
- Lucas, R. E. (1972). Expectations and the neutrality of money. Journal of Economic Theory, 4(2), 103–124.
- Sargent, T. J., & Wallace, N. (1976). Rational expectations and the theory of economic policy. Journal of Monetary Economics, 2(2), 169–183.
- Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25(2), 383–417.
- Grossman, S. J., & Stiglitz, J. E. (1980). On the impossibility of informationally efficient markets. American Economic Review, 70(3), 393–408.
- Taylor, J. B. (1980). Aggregate dynamics and staggered contracts. Journal of Political Economy, 88(1), 1–23.
- Sargent, T. J. (1993). Bounded Rationality in Macroeconomics. Oxford: Oxford University Press.
- Evans, G. W., & Honkapohja, S. (2001). Learning and Expectations in Macroeconomics. Princeton, NJ: Princeton University Press.
- Mankiw, N. G., & Reis, R. (2002). Sticky information versus sticky prices. Quarterly Journal of Economics, 117(4), 1295–1328.
- Sims, C. A. (2003). Implications of rational inattention. Journal of Monetary Economics, 50(3), 665–690.
- Coibion, O., & Gorodnichenko, Y. (2015). Information rigidity and the expectations formation process. American Economic Review, 105(8), 2644–2678.
- Gabaix, X. (2020). A behavioral New Keynesian model. American Economic Review, 110(8), 2271–2327.