Economics Bounded Rationality Questions Medium
Bounded rationality and rational expectations are two concepts that are closely related in the field of finance.
Bounded rationality refers to the idea that individuals have limited cognitive abilities and information processing capabilities when making decisions. It suggests that individuals make decisions based on simplified models and heuristics, rather than fully optimizing their choices. In other words, individuals are rational, but within the bounds of their cognitive limitations.
On the other hand, rational expectations theory in finance assumes that individuals make decisions based on all available information and have rational expectations about future events. It suggests that individuals form expectations about future outcomes by using all relevant information and incorporating it into their decision-making process.
The relationship between bounded rationality and rational expectations lies in the recognition that individuals, while bounded in their rationality, still strive to make the best decisions given their limited cognitive abilities. Bounded rationality acknowledges that individuals cannot fully optimize their decisions due to cognitive limitations, but they still aim to make rational choices based on the information available to them.
In finance, individuals with bounded rationality may not be able to process all available information or fully understand complex financial models. However, they still form expectations about future financial outcomes based on the information they can process. These expectations may not be fully rational or accurate, but they represent the best possible decisions individuals can make given their cognitive limitations.
Therefore, bounded rationality and rational expectations are interconnected in the sense that individuals with bounded rationality still strive to form rational expectations about future financial events, even though their decision-making process may be simplified or based on heuristics.