The term “Expectations” could mean multiple things depending on who you ask. If you ask a parent what their expectations are, they might say “I expect my kids to make their bed every day.” If you ask an elementary school teacher, they might say “I expect my students to complete their homework on time.” What makes the expectations rational is when we take in to account past performance and any other information we have available. We can rationally expect an A student with a proven track record to complete their homework on time, but is it rational to expect the aloof slacker in the back of the class to do the same?
Our Rational Expectations in everyday life drive much of what we do and the decisions we make, and the theory behind it is rooted in economics. Influencing the information available will in turn influence people’s expectations, and influencing the rational expectations of us and those around us will steer the outcome in the direction of the new information.
Going in for a job interview, you come prepared with your resume and letters of recommendation. In the interview they ask you a series of questions to determine the value you will bring to that organization. The employer then takes the information you provided, combines it with market data on the incomes of other people with similar jobs, and reaches a conclusion on what to pay you based upon all available information. If you were to interview with many different companies, you would get a range of values, some outliers on the high and low end that don’t fit in with the group, but, for the most part the offers would be in the same pay range. All of these companies would value you differently depending on how they have interpreted the information available. If we then take the average value of all of these offers, we would get a market value of you as an employee.
Rational expectations in economics work the same way. These businesses have valued you as an employee based on your expected performance in the future when taking in to account all of the available information from the past and present. In the market, valuations are created in the same way. In stocks, for example, analysts make estimations at the beginning of the quarter as to what the company will earn during that quarter. At the end, the company reveals the true earnings. If the company exceeds expectations, then we should expect a rise in the prices of their stock. This is because as new information becomes available, people’s expectations are influenced, and the outcome is that analysts will revise their expectations to reflect the higher earnings.
We refer to all of the people in the market as the “aggregate.” In the Supply/Demand graph below it says AS/AD. This means the collective supply of everyone in the market and the collective demand of everyone in the market. The graph shows the effect of a positive change in expectations in relation to the bond market. Even though there is no immediate change in what companies are producing, people’s demand for their bonds increases because they expect better performance in the future.
This process happens to every stock, every bond, and every commodity on the market. Prices are determined by expectations because investments are about what is supposed to happen in the future when taking in to account available information and past performance. Every investor in the market does research and makes choices to buy or sell at any moment. This is why markets are generally an efficient way of determining value.
Cover image used courtesy of JoeyBLS Photography.