theory of rational expectations (TRE)

Definition

Economic-behavior observation according to which: (1) On average, people can quite correctly predict future conditions and take actions accordingly, even if they do not fully understand the cause-and-effect (causal) relationships underlying the events and their own thinking. Thus, while they do not have perfect foresights, they construct their expectations in a rational manner that, more often than not, turn out to be correct. Any error that creeps in is usually due to random (non-systemic) and unforeseeable causes. (2) In efficient markets with perfect or near perfect information (such as in modern open-market economies) people will anticipate government's actions to stimulate or restrain the economy, and will adjust their response accordingly. For example, if the government attempts to increase the money supply, people will raise their prices and wage demands to compensate for the inflationary impact of the increase. Similarly, during periods of accelerating inflation, they will anticipate stricter credit controls accompanied by high interest rates. Therefore they will attempt to borrow up to their credit capability, thus largely nullifying the controls. This theory was proposed not as a plausible explanation of human behavior, but to serve as a model against which extreme forms of behavior could be compared. It was developed by the US economist Robert Lucas (born 1937) who won the 1955 Nobel Prize for this insight. Not to be confused with rational choice theory. Called also rational expectations hypothesis.