Introductory Notes on Rational Expectations 1 Overview

The theory of rational expectations (RE) is a collection of assumptions regarding the manner in which economic agents exploit available information to form their expectations. In its stronger forms, RE operates as a coordination device that permits the construction of a “representative agent” having “representative expectations.” Section 2 of these introductory notes on RE provides several alternative RE definitions (collections of assumptions), both weak and strong. Section 3 uses two illustrative examples to demonstrate standard solution techniques for the determination of strong-form RE solutions. The statistical implications of RE are discussed in Section 4, followed by a discussion in Section 5 of RE solutions as fixed-point solutions. A brief but rigorous discussion of probability spaces and the meaning of conditional expectation, which are essential theoretical underpinnings for RE, can be found in a series of appendices. For simplicity, these RE definitions focus solely on first moments, i.e., on mean (expected) values. However, once these basic definitions are grasped, it is rather straightforward to modify these definitions to cover the more general case of “rational expectations” regarding the entire probability distribution governing a stochastic variable.