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Rational Expectations: a Fallacious Foundation for Studying Crucial Decision Making Processes

In: Inflation, Open Economies and Resources

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  • Paul Davidson

Abstract

Proponents of the rational expectations hypothesis (hereafter REH) claim they have developed a general theory of how expectations are formed. To assure that these rational expectations generate efficient, unbiased forecasts which do not display any persistent errors when compared to the actual outcome over time, REH theorists assume that information exists and is available for processing by all decision makers. This information, consisting primarily of quantitative time series data, it is assumed, is a finite realization of a stochastic process; from this data the probability distribution of actual outcomes today and for all future dates can be estimated. Or as John Muth puts it, ‘the hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or more generally, the “subjective” probability of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distribution of outcomes)’ (1961, p. 316).

Suggested Citation

  • Paul Davidson, 1991. "Rational Expectations: a Fallacious Foundation for Studying Crucial Decision Making Processes," Palgrave Macmillan Books, in: Louise Davidson (ed.), Inflation, Open Economies and Resources, chapter 12, pages 123-138, Palgrave Macmillan.
    • Handle: RePEc:pal:palchp:978-1-349-11516-7_12
    DOI: 10.1007/978-1-349-11516-7_12
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    1. Paul Davidson, 1992. "International Money and the Real World," Palgrave Macmillan Books, Palgrave Macmillan, edition 0, number 978-0-230-37809-4, March.
    2. Vasilev, Aleksandar & Maksumov, Rashid, 2010. "Critical analysis of Chapter 23 of Keynes’s Notes on Mercantilism in The General Theory of Employment, Interest and Money (1936)," EconStor Research Reports 155318, ZBW - Leibniz Information Centre for Economics.
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