rational expectations hypothesis

*noun*; a method of representing the economy as the sum of many identical individuals and firms, each represented by a system of mathematical equations. The Rational Expectations Hypothesis (REH) takes its name from the premise that economic actors, i.e., everyone, do not make consistent errors about the present or future behavior of markets.

REH was devised mainly as a rebuke to Keynesian economics, and in particular, the strategy of fiscal policy or monetary policy.

According to the REH, fiscal policy does not alter aggregate demand because the "average" person recognizes that her lifetime income is not increasing--so she needs to save rather than spend the stimulus money, in anticipation of higher taxes in the future.

At the same time, monetary policy does not work because it relies on lowering interest rates to make more money available; more money means inflation, but people have to be deceived into thinking prices for their product are going up, so they will expand production. According to REH, people or firms will figure this out, and see increased demand as mere inflation. Instead of increasing output and employment, they'll want to raise prices so they can meet their future bills.

According to REH, both monetary and fiscal policy rely on illusions to work; and since people (on average) will make rational estimates o the future, they will defeat these illusions.

The rational expectations hypothesis states that we can break the realization of a return into an expected return that depends on the current information set and an unexpected component that depends only on new information.

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