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

Under the rational expectations hypothesis, which statement best describes how economic agents form their forecasts of a variable such as inflation?

Rational expectations means agents use all available relevant information when forecasting, so their forecasts are unbiased. Errors still occur but average zero and cannot be predicted from known information. This differs from adaptive expectations, which only adjust forecasts gradually using past errors.

  1. AThey extrapolate the most recent observed value of the variable into the future
  2. BThey use all available relevant information and their forecast errors are, on average, zero and unrelated to that informationCorrect
  3. CThey adjust their forecast each period by a fixed fraction of the previous forecast error
  4. DThey always forecast the variable perfectly with no error in any period
  5. They rely solely on the forecasts published by the government

Explanation

Rational expectations means forecasts use all available information, so the expectation equals the true conditional expected value. Forecast errors are therefore random, have zero mean and cannot be predicted from the information set. Option 3 describes adaptive expectations, and option 4 wrongly claims no errors at all.

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