Econometrica, Vol, 29, No. 3 (July 1961) RATIONAL EXPECTATIONS AND THE THEORY OF PRICE MOVEMENTS BY JOHN F. MUTH In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory. In particular, the hypothesis asserts that the economy generally does not waste information, and that expectations depend specifically on the structure of the entire system. Methods of analysis, which hypothesis is illustrated by introducing commodity speculation into the 1. INTRODUCTION THAT EXPECTATIONS of economic variables may be subject to error has for some time, been recognized as an important part of most explanations of changes in the level of business activity. The"ex ante"'analysis of the tockholm School--although it has created its fair share of confusion--is a highly suggestive approach to short-run problems. It has undoubtedly been a major motivation for studies of business expectations and intentions data As a systematic theory of fluctuations in markets or in the economy, he approach is limited, however, because it does not include an explanation of the way expectations are formed. To make dynamic economic models mplete, various expectations formulas have been used. There is, however, little evidence to suggest that the presumed relations bear a resemblance to the way the economy works. 2 What kind of information is used and how it is put together to an estimate of future conditions is important to understand becaus te me character of dynamic processes is typically very sensitive to the way ex- pectations are influenced by the actual course of events. Furthermore it is often necessary to make sensible predictions about the way expectations would change when either the amount of available information or the struc 1 Research undertaken for the project, Planning and Control of Industrial operations under contract with the Office of Naval Research. Contract N-onr-760-(01), Project NR047011. Reproduction of this paper in whole or in part is permitted for any purpose of the united states Government An earlier version of this paper was presented at the winter Meeting of the E nometric Society, Washington, D. C, December 30, 1959 I am indebted to Z, Griliches, A. G. Hart, M. H. Miller, F. Modigliani, M. Ne and H. White for their comments 2 This comment also applies to dynamic theories in which expectations do not explicitly appear. See, for example, Arrow, Block, and Hurwicz [3, 4Econometrica, Vol. 29, No. 3 (July 1961) RATIONAL EXPECTATIONS AND THE THEORY OF PRICE MOVEMENTS1 BY JOHN F. MUTH In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory. In particular, the hypothesis asserts that the economy generally does not waste information, and that expectations depend specifically on the structure of the entire system. Methods of analysis, which are appropriate under special conditions, are described in the context of an isolated market with a fixed production lag. The interpretative value of the hypothesis is illustrated by introducing commodity speculation into the system. 1. INTRODUCTION THAT EXPECTATIONS ofeconomic variables may be subject to error has, for some time, been recognized as an important part of most explanations of changes in the level of business activity. The "ex ante" analysis of the Stockholm School-although it has created its fair share of confusion-is a highly suggestive approach to short-run problems. It has undoubtedly been a major motivation for studies of business expectations and intentions data. As a systematic theory of fluctuations in markets or in the economy, the approach is limited, however, because it does not include an explanation of the way expectations are formed. To make dynamic economic models complete, various expectations formulas have been used. There is, however, little evidence to suggest that the presumed relations bear a resemblance to the way the economy works.2 What kind of information is used and how it is put together to frame an estimate of future conditions is important to understand because the character of dynamic processes is typically very sensitive to the way ex￾pectations are influenced by the actual course of events. Furthermore, it is often necessary to make sensible predictions about the way expectations would change when either the amount of available information or the struc- 1 Research undertaken for the project, Planning and Control of Industrial Operations, under contract with the Office of Naval Research. Contract N-onr-760-(01), Project NR 04701 1. Reproduction of this paper in whole or in part is permitted for any purpose of the United States Government. An earlier version of this paper was presented at the Winter Meeting of the Eco￾nometric Society, Washington, D.C., December 30, 1959. I am indebted to Z. Griliches, A. G. Hart, M. H. Miller, F. Modigliani, M. Nerlove, and H. White for their comments. 2 This comment also applies to dynamic theories in which expectations do not explicitly appear. See, for example, Arrow, Block, and Hurwicz [3, 4]. 315