The Role of Expectations in Economics

by Nick Robinson; Updated September 26, 2017

Economists define "expectations" as the set of assumptions people make about what will occur in the future. These assumptions guide individuals, businesses and governments through their decision-making processes, making the study of expectations central to the study of economics.

The Role of Expectations

People's guesses about what will occur in the future seem to influence almost every aspect of the economy. A restaurant manager's prediction about how many customers he can expect over summer may prompt him to hire more staff, or reduce orders for fresh produce. A bond trader's expectation of how the Federal Reserve will change interest rates will alter her trading strategy. A CEO of a publicly traded company's guess about how regulators in Washington will behave may change his expansion plans.

In a very real sense, economics is the study of how people make decisions. Expectations about what will happen in the future lie at heart of every choice, so they are the heart of economics as a discipline.

Rational Expectations Theory

The theory of rational expectations, first outlined by Indiana professor John Murth in the 1960s, is the approach most economists take towards understanding how people think about the future. The theory assumes that people generally are self-interested and try to make correct guesses about what will happen. While many individuals may hold mistaken expectations, according to the theory, large groups of people tend to make the right predictions in aggregate. That is, it is very unusual for actual events to contradict average expectation over the long term.

The rational expectations theory has influenced almost every other element of economics. The theory is an underlying and critical assumption in the efficient markets hypothesis, for instance. This predicts that because people hold generally rational views about the future, it should be difficult or impossible to make more money on the stock market than the average growth rate. Similarly, governments often use rational expectation theory to set their monetary policies.

Irrational Expectations

Some economics dispute the notion that people generally hold rational expectations about the future. Instead, they argue people are just as likely to form irrational opinions about what will happen. Nobel laureate Robert Schiller, for example, argues that the housing crisis beginning in 2008 resulted from irrational expectations about real estate prices. The real estate market irrationally decided home prices always go up. This prompted sellers to raise prices and buyers to pay a premium. Based on incorrect expectations, the market turned into a bubble. When prices finally did fall back to earth, the bubble deflated with enormous consequences.

About the Author

Nick Robinson is a writer, instructor and graduate student. Before deciding to pursue an advanced degree, he worked as a teacher and administrator at three different colleges and universities, and as an education coach for Inside Track. Most of Robinson's writing centers on education and travel.

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