For macroeconomists, an individual is rational if she uses her understanding of the way the economy works in making decisions that do not conflict with her objectives.
In this paper, we reconsider how macroeconomists can build models that are compatible with rational decision-making. We show that, by design, the Rational Expectations Hypothesis (REH) is an abstraction of rational decision-making in a world in which individuals’ knowledge about the process underlying market outcomes does not grow over time. This conclusion concerning REH’s limited domain of applicability leads us to propose the contingent expectations hypothesis (CEH) for modeling rational forecasting in markets in which outcomes are driven in part by the growth of participants’ knowledge.