Traveling to Europe: A Lesson in Rational Expectations
A friend of mine is traveling to Europe later this week. Last week he sent me a note asking what impact the election of Francois Hollande in France and the loss of support for pro-Eurozone political parties in the Greek elections would have on the value of the dollar relative to euro. Both events were widely predicted in the news stories leading up to the elections which occurred on Sunday, May 6. My friend was holding off purchasing euros for his trip until after the election in expectation (or at least hope) that these election results would result in a fall in the value of the euro. I replied that currency traders had already factored in the probabilities of both events into their trading strategies—i.e., they were not going to wait--and thus any impact on the euro, if any, would be temporary unless there was a real surprise in the results.
The basis for my response is the concept of rational expectations which posits that market participants (in this case, currency traders) use all available information to form expectations about the future and act on these expectations in the present rather than waiting. Were they to delay acting, they would forgo possible profits or endure losses. The application of rational expectations to macroeconomic policy has led some like Nobel Prize winning economist Robert Lucas to argue that fiscal and monetary policies are bound to be impotent since market participants will anticipate the impacts of, say, policies designed to stimulate the economy, and respond in ways that offset the stimulus.
There are, of course, critics of this argument, but rational expectations is a concept that has wide application in economic analysis. When the news of the election results in France and Greece came in the euro tumbled initially but within a few hours it had almost fully recovered. At the end of Monday, May 7, the euro was very close to where it was at the market close on Friday. Score one point for rational expectations.
Don Norman, Senior Economist