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If we take P to be the equilibrium price in a simple market, determined by supply and demand; the theory of rational expectations says that the actual price will only deviate from the expectation if there is an ‘information shock’ caused by information unforeseeable at the time expectations were formed.
Rational expectations theory therefore defines this kind of expectations as being identical to the best guess of the future (the optimal forecast) that uses all available information. However, without further assumptions, this theory of expectations determination makes no predictions about human behavior and is empty. Thus, it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. As a result, rational expectations do not differ systematically or predictably from equilibrium results. That is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random. In an economic model, this is typically modeled by assuming that the expected value of a variable is equal to the value predicted by the model, plus a random error term representing the role of ignorance and mistakes.
Keyness Approach to Expectation
The General Theory of Employment Interest and Money by J. M. Keynes (1936) was the starting point of a magnificent theoretical revolution; it meant to be a revolution in terms of economic thought against the classical theory and laissez-faire.
1. Keynes, JM. l937. The general theory of employment. The Quarterly Journal of Economics 51. Reprinted in Snowdon & Vane 2005: 225, 464
2. Parguez, A., 2000, A Monetary Theory of the Public Finance, Paper presented at the Fifth Post Keynesian Workshop on Post Keynesian Economics for the 21st Century, Knoxville, Tennessee, (June).
3. Snowdon, B and Vane, H. 2005. Modern macroeconomics. Cheltenham: Edward Elgar.
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