#### RATIONAL EXPECTATION HYPOTHESIS (REH)

The expectation on the future realisation of an economic variable is rational if the agent uses all the available and useful information to predict it. *The Rational expectation hypothesis*** **(*REH*), originally proposed by Muth (1961), is one of the main features of the so-called *New Classical Macroeconomics* and assumes that economic agents do not make systematic errors when predicting the future. According to the *REH*, the expectation at time *t* of the realisation of *x* at time *t *+ 1 can be written as follows:

where the subjective expected level of a variable held by economic agents is equal to the mathematical expectation of the probability distribution conditional on the information set available at time *t .* It is worth noticing that includes all the information concerning the policies to be carried out by the government in the future. Under the *REH*, agents formulate unbiased forecasts of future values of an economic variable and their forecast error is on average equal to zero:

The* REH *assumes the best use of available information and that the agents’ *subjective* distribution of expectations corresponds to the *objective* probability distribution of the true model describing the economy.

Bibliography

Muth J.F. (1961) "Rational Expectations and the Theory of Price Movements", *Econometrica*, Vol. 29(3), pp. 315-335

Sargent T.S. (1987), "Rational expectations" *The New Palgrave: A Dictionary of Economics,* Vol. 4, pp. 76-79.

Editor: Lorenzo CARBONARI

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