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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

Under the rational expectations hypothesis, how do economic agents form their expectations of a future variable such as inflation?

Under rational expectations, agents use all available relevant information and a correct understanding of the economy. Their expectations equal the true conditional expected value, so forecast errors have zero mean and are unpredictable from information already available. Extrapolating past values is adaptive expectations, not rational expectations.

  1. ABy extrapolating the average of the last few observed values of the variable
  2. BBy using all available relevant information, including knowledge of how the economy works, so that forecast errors are unpredictable on averageCorrect
  3. CBy assuming that the future value will equal the current value
  4. DBy following the forecasts of the central bank without any adjustment
  5. By placing greater weight on the most recent forecast error only

Explanation

Rational expectations means agents use all available information and the correct economic model, so expectations equal the true conditional expectation. Forecast errors then have zero mean and cannot be predicted from available information. Extrapolating past values describes adaptive or naive expectations.

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