Wednesday, November 23, 2016

In defense of rational expectations models

By Scott Sumner.
"David Glasner has a post criticizing the rational expectations modeling assumption in economics:
What this means is that expectations can be rational only when everyone has identical expectations. If people have divergent expectations, then the expectations of at least some people will necessarily be disappointed -- the expectations of both people with differing expectations cannot be simultaneously realized -- and those individuals whose expectations have been disappointed will have to revise their plans. But that means that the expectations of those people who were correct were also not rational, because the prices that they expected were not equilibrium prices. So unless all agents have the same expectations about the future, the expectations of no one are rational. Rational expectations are a fixed point, and that fixed point cannot be attained unless everyone shares those expectations. Beyond that little problem, Mason raises the further problem that, in a rational-expectations equilibrium, it makes no sense to speak of a shock, because the only possible meaning of "shock" in the context of a full intertemporal (aka rational-expectations) equilibrium is a failure of expectations to be realized. But if expectations are not realized, expectations were not rational.

I see two mistakes here. Not everyone must have identical expectations in a world of rational expectations. Now it's true that there are ratex models where people are simply assumed to have identical expectations, such as representative agent models, but that modeling assumption has nothing to do with rational expectations, per se.

In fact, the rational expectations hypothesis suggests that people form optimal forecasts based on all publicly available information. One of the most famous rational expectations models was Robert Lucas's model of monetary misperceptions, where people observed local conditions before national data was available. In that model, each agent sees different local prices, and thus forms different expectations about aggregate demand at the national level.
It's also wrong to say:
But if expectations are not realized, expectations were not rational.
Suppose I am watching the game of roulette. I form the expectation that the ball will not land on one of the two green squares. Now suppose it does. Was my expectation rational? I'd say yes---there was only a 2/38 chance of the ball landing on a green square. It's true that I lacked perfect foresight, but my expectation was rational, given what I knew at the time.

In 2006, it might have been rational to forecast that housing prices would not crash. If you lived in many countries, your forecast would have been correct. If you happened to live in Ireland or the US, your forecast would have been incorrect. But it might well have been a rational forecast in all countries."

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