The Theory Of Rational Expectations

John F. Muth of Indiana University coined the theory of rational expectations in the early sixties. He used the term to describe economic situations under which, the outcome depends on peoples’ expectations. The theory greatly applies to the stock markets around the world, as, if investors expect the price of common stock of a particular company to come down they go on a selling spree and the result is obvious, and when they expect it to go up they buy heavily and hence, the prices spirally. To conclude the cornerstone of the theory, we can suggest that, people behave or take decisions in order to maximize the value of an outcome and they keep getting feedback from the transactions, as to what they expected and what they actually received.

In this way there expectations over a period of time tend to stabilize because of the result of the past outcomes. In other words, their expectations become rational.

The theory of rational expectations is often put into practice in many economic as well as finance models. One such execution of the model is related to The Efficient Markets Theory of Stock Prices, which states that there are three forms of the efficient-market hypothesis, namely, weak form, semi strong form, and strong form. Weak form which is also known as the Random-walk theory suggests that there is no purpose of examining the charts as the share pieces fully reflect the historical sequences. Semi-strong form on the other hand suggests that current market prices not only reflect the historical chart patterns, but also reflect all the publicly available knowledge, so this kind of information is almost always useless for the analysts and the investors.