International Banking – Rational Expectations Theory
Q: Assume that your economics professor announces to your class that after thirty years of giving exams only on scheduled dates, this semester she will give only surprise quizzes. What is the rational expectation response to this new policy? Why does your self-interest require that you change your behavior? What would the consequences be for students who changed their expectations about exams adaptively?
A: Theory of Rational Expectations explains that people make their expectations match their best possible guess of the future, using all available information they have (Mishkin, 2004). Sargent explains it with other words: Our expectations are set by our mind based on our knowledge, past experience, and our personal rationality (N.d.).
In our case, there is not much information available because this is an unprecedented situation for the last 30 years! Students are used to having exams on pre-scheduled dates to date. The only information they have for now is that surprise quizzes will be the new practice!
As said for the Rational Expectations theory, students’ next expectation will be made by their knowledge, past experience and rationality. However, their knowledge is limited as the information is limited. Their past experience includes only the pre-scheduled exams which used to be usually in Week 7 and 14. So, their rationality may tend to expect some quizzes at least in those weeks! This is one way to interpret what Rational Expectations Theory dictates to us. Other than this, we can also say their response will include trying to adapt this new practice by having some changes in behaviours.
This new practice may force students to alter their behaviours as they would feel it is necessary for their own interest. Theory of Rational Expectations supports this as it states that people behave rationally – with rationality defined as actions to serve their self-interest (Silk, 1983). In our case, as a student, my self-interest forces me to alter my behaviours according to the new policy because if I don’t, I will face with possible consequences of receiving a low grade, or even failing the course!
So, some rational students may adjust their behaviours adaptively and start studying the class materials weekly. Those who changed themselves adaptively would be likely to experience following:
- Studying before every classes keeping in mind that there may be a surprise quiz in class time
- Keeping up with the course materials and textbook as they will be studying weekly
- Learning better than before due to weekly review and practicing learning outcomes more often that before
- Higher retention rate of what is learned in the course
- Possibly, higher grade overall, and higher satisfaction on the Professor’s end
Mishkin, F. S. (2004). The economics of money, banking and financial markets. Harlow, Essex: Pearson Education Limited.
Sargent, T. J. (N.d). Rational Expectations. The Library of Economics and Liberty. Retrieved June 17, 2020, from https://www.econlib.org/library/Enc/RationalExpectations.html
Silk, L. (1983). Economic Scene; On Rational Expectations. New York Times. Retrieved June 17, 2020, from https://www.nytimes.com/1983/11/11/business/economic-scene-on-rational-expectations.html