Expectation Theory

The theory of rational expectations (RE) is about the collection of assumptions related to how economic agents or policymakers exploit available market information to form expectations.

The RE factor correlates with a certain type of representative expectations or agents.

A strong RE has intuitive appeal where the economists create theoretical models that are based on assumptions to get a smart and well-informed model for the economy. 

Pure Expectations Theory explains the movement of long term interest rates by the market expectation for future short term rates.

It means to maximize discount on a certain asset, the investors try to choose an optimum portfolio -

for purchasing and consecutive holding of bonds where maturity is equal to the planned investment term or rolling over short term instruments

or buying long term bonds and selling such options before its maturity.  

It is further classified into unbiased that maintain long term interest rates are perfectly determined by market expectations for future short term interest rates.

Expectation theory can be of two types – pure/unbiased and with risk premium and capital asset pricing model (CAPM).

CAPM was developed for risky asset holding and it tries to create a cross-sectional relationship between the yields on various assets with different risk factors.

The concept of this model is that the yield of the risky investments like alternative finance investment bonds can be described as the sum of the yield of safe assets and investments plus the relative risk factor associated with the asset class.

• There are many other categories like the constant risk premium, the liquidity, and the time-varying hypothesis.  

• Expectations play a key role in economic theories that are used to design macroeconomic models.

• It is a central part of the planning related to economic life starting from decision makings like how to buy a car, the amount of money spent on education, or others.  

• Adaptive models are based on past observations and rationals are identical to forecasts made for macroeconomic theories. 

Different types of models – 

• Traditional structured - It follows the Keynesian paradigm that, mainly, features adjustment of prices. 

• Rational – It is the one that is consistent with the model structure. 

• Equilibrium business cycle - It assumes - labour and goods markets are always in equilibrium. 

• Vector autoregression – It employs a small number of estimated equations to summarise the dynamic behaviour of entire macroeconomic. 

• Small vector autoregression - It is used to determine key economic measures.