RATIONAL EXPECTATION HYPOTHESIS (REH)

The expectation on the future realisation of an economic variable is rational if the agent uses all the available and useful information to predict it. The Rational expectation hypothesis (REH), originally proposed by Muth (1961), is one of the main features of the so-called New Classical Macroeconomics and assumes that economic agents do not make systematic errors when predicting the future. According to the REH, the expectation at time t of the realisation of x at time t + 1 can be written as follows:
                                                                
where the subjective expected level of a variable  held by economic agents is equal to
the mathematical expectation of the probability distribution conditional on the information set available at time t . It is worth noticing that includes all the information concerning the policies to be carried out by the government in the future. Under the REH, agents formulate unbiased forecasts of future values of an economic variable and their forecast error is on average equal to zero:
                                                                 
The REH assumes the best use of available information and that the agents’ subjective distribution of expectations corresponds to the objective probability distribution of the true model describing the economy. 
Bibliography
Muth J.F. (1961) "Rational Expectations and the Theory of Price Movements", Econometrica, Vol. 29(3), pp. 315-335
Sargent T.S. (1987), "Rational expectations" The New Palgrave: A Dictionary of Economics, Vol. 4, pp. 76-79.
Editor: Lorenzo CARBONARI
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