Rational Expectations

John Muth introduced the idea of rational expectations in 1961, and his argument can be explained with a simple story (Muth 1961). Suppose that farmers make planting decisions based on adaptive expectations formed from last year’s prices. A year of bad weather yields high prices, which lead to overplanting, which then leads to low prices, which then leads to underplanting, which then leads to high prices, and so on. A rational farmer would understand the underlying supply-and-demand model as well as the lack of serial correlation in weather shocks, and would therefore plant the same amount each year regardless of previous price outcomes. In essence, rational expectations dictate that when economic agents optimize and when the underlying economic system is in equilibrium, the agents’ expectations about...