Blog Post

Blogs review: Revisiting the case for rational expectations

What’s at stake: The debate about what determines the expectations of economic agents and what model of expectations to use in macroeconomic models has been central to economics since the 1970s. Rational expectations, equal to the statistical expected values of the variables in question, opposed to adaptive expectations that are determined by past observations of the variables, were a central component of the New Classical critique of Keynesian economics and the debate has been active ever since. Recently, a post by Lars Syll, in which he attacks Simon Wren-Lewis for his continued defence of rational expectations, has provoked a reaction by Wren-Lewis, sparking a debate involving heterodox and mainstream economists.

By: Date: November 14, 2013 Topic: Global Economics & Governance

What’s at stake: The debate about what determines the expectations of economic agents and what model of expectations to use in macroeconomic models has been central to economics since the 1970s. Rational expectations, equal to the statistical expected values of the variables in question, opposed to adaptive expectations that are determined by past observations of the variables, were a central component of the New Classical critique of Keynesian economics and the debate has been active ever since. Recently, a post by Lars Syll, in which he attacks Simon Wren-Lewis for his continued defence of rational expectations, has provoked a reaction by Wren-Lewis, sparking a debate involving heterodox and mainstream economists.

The importance of past and present information

Lars P Syll argues that Rational Expectations could only apply to a fictitious, ergodic world governed by stable and stationary stochastic processes. In the real world, however, the future is to a large extent unknowable and uncertain. Structural breaks and regime shifts occur, time and history matter. Events may not be caused by time-invariant stochastic processes with stable probability distributions. Under those circumstances, it is quite possible for agents to make mistakes that turn out to be systematic.

Simon Wren-Lewis writes that if he were to focus in detail on how expectations were formed and adjusted, he would turn to the large mainstream literature on learning. The validity of macroeconomic ideas should be checked within realistic learning environments. However, for modelling purposes, more simplicity is required. One essentially has the binary choice between rational expectations or naive agents with something like adaptive expectations. The problem with adaptive expectations is that they come down to assuming that expectations depend solely on past observations, without regard for monetary policy and the current state of the economy.  Given the importance of decisions based on expectations, that seems too simplistic.

Robert Waldmann finds it obvious that it is better to assume adaptive than rational expectations when attempting to model advanced industrial economies and to guide policy. It is plainly true that most economic agents in the USA quite clearly ignore what economists and the media say about inflation. And under naive expectations, irrational speculative bubbles will arise, in which agents assume some asset price will increase because it has in the past. That is consistent with the data (but the data can also be reconciled with the rational expectations assumption. The problem is – any data can be reconciled with it: It is not a falsifiable theory).

In an older article, David Levine writes that he does not think there are viable alternatives to rational expectations in economics despite the resultant inability to predict crises. This “uncertainty principle” in economics is due to the fact that under any form of expectations other than rational expectations, a theory built on those expectations would be wrong once people start to believe and act upon it (this is essentially the Lucas critique).

Simplicity in models and agents’ behaviour

Simon Wren-Lewis argues that while rational expectations may seem a strong assumption, the approach resembles that of microeconomics to other subjects: Firms may not know the true demand curves for their products, yet the assumption of profit-maximising prices may be a better approximation to how they choose prices than a model where they have a fixed mark-up on costs. So it also seems consistent to also assume that agents use relevant and available information to generate expectations when those expectations matter. And how else would one make sense of a whole forecasting industry, and the newsworthy character of macro forecasts?

Mark Thoma takes a measured view of rational expectations. On the one hand, it would be foolish to assume people didn’t use new information and purely extrapolated from past trends. Who would assume a trend will continue when there is good information saying otherwise? And one should think that people will react to announced changes in policies. On the other hand, it is quite a stretch to assume that people fully understand the policy rules used as well as how they will impact the economy.  Simplifications, rules of thumb or hard-wiring may explain quite a bit – e.g. why we can catch a ball in flight without solving complicated differential equations – and the correction of individual errors on markets may explain even something more, but it is to be doubted that it extends to fully approximating the functioning of complex markets. Rational expectations may be a good benchmark, just like the assumption of a perfect vacuum in physics, and may approximately hold in some contexts such as simple games and financial markets.  However, it would be a mistake to assume they apply universally.

Nick Rowe writes that one should expect people to use rules of thumb in reality. This is a rational strategy for individuals as long as the world is well approximated by the rule used. For any naive way of forming expectations, there exists a world in which that naive way of forming expectations would be rational. In a world where the price level followed a random walk – something like the Gold Standard world – the naive expectation of 0% inflation is rational. In a world where the price level followed a random walk plus 2% drift, roughly a 2% inflation target world, the naive expectation of 2% inflation would be rational. And if the inflation rate followed a random walk, the naive expectation that next period’s inflation rate would be the same as last period’s inflation rate would be rational. It’s when the world changes that things get tricky.  The naive expectations that were rational in the old world aren’t rational in the new world. This comes down to an argument for small c-conservatism in monetary policy rules and elsewhere in order to keep expectations rational for longer than they otherwise would be.

Expectations and data

Robert Waldmann points out that the Michigan Survey (inflation expectations of ordinary people) shows that inflation expectations are closely correlated to current CPI inflation – except when large external shocks such as oil price shocks occur. And in recent years, survey forecast inflation is persistently higher than actual inflation – while people’s estimates of current inflation also exceed actual figures. This does not seem in tune with rational expectations either and rather point towards backwards-looking expectation formation.

Source: Stumbling and Mumbling / Chris Dillow, using Bank of England data

Chris Dillow  points out that in the data, expected inflation and perceived inflation are strongly correlated. While this may be consistent with some rational expectations, it is also largely consistent with a simple rule of thumb: expect inflation to be what it is now, but adjust down if inflation is unusually high, and up if it’s unusually low. However, this rule of thumb does not seem to hold for exceptional circumstances. During the recession, inflation expectations were lower than those this rule of thumb would generate. Maybe, it is reasonable to suspect that inflation expectations are indeed formed by backward looking simple rules of thumb in normal times – but in exceptional times, people abandon rules of thumb for more complex processes as the costs of being wrong increase.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read article More on this topic More by this author

Opinion

What else China can do to support growth in the short term

Recent data shows the downward spiral in the Chinese economy has somewhat eased on a cyclical basis, but it is still too early to cheer for a full stabilization.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 23, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Resuming the EU-US trade talks

Maria Demertzis sits down with Bruegel senior fellow André Sapir to break down the news, discussing the events leading up to the renewed EU-US trade talks, and the likely future course.

By: The Sound of Economics Topic: Global Economics & Governance Date: April 23, 2019
Read article More on this topic

Blog Post

The next step of the Belt and Road Initiative: Multilateralisation with Chinese characteristics

The increasingly broad objective of China's Belt and Road Initiative has attracted the attention not only from the BRI members, but also from other major players such as the United States and the European Union.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: April 18, 2019
Read article More on this topic More by this author

Blog Post

Why China's current account balance approaches zero

China’s current account is projected to be balanced within the next few years. Observers disagree whether this is due to structural factors or Chinese policy. We review their assessments of the Chinese saving and investment situation and what this implies for the future.

By: Michael Baltensperger Topic: Global Economics & Governance Date: April 15, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's cut: EU-China partnership after the 21st EU-China summit

Guntram Wolff discusses with Alicia Garcia Herrero the results of the 21st EU-China Summit

By: The Sound of Economics Topic: Global Economics & Governance Date: April 12, 2019
Read article Download PDF More on this topic More by this author

Working Paper

Europe in the midst of China-US strategic competition: What are the European Union's options?

With the trade conflict between the United States and China bringing China-US strategic competition into the open, the European Union faces an urgent question: how to position itself in the competition.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 8, 2019
Read article More on this topic More by this author

Opinion

ICT revolution key to populist political surge

Developments in digital technology have prompted a ‘tabloidisation’ of traditional media, created opportunities for the misuse of information online, and closed the decision-making horizon for politicians.

By: Marek Dabrowski Topic: Global Economics & Governance Date: April 4, 2019
Read article More on this topic More by this author

Opinion

Can the emerging economic powers govern the globe?

Can a G7 dominated by developing nations provide the impulse to global governance as did the old G7? The answer is no.

By: Uri Dadush Topic: Global Economics & Governance Date: April 4, 2019
Read article More by this author

Opinion

Europe and the new imperialism

For decades, Europe has served as a steward of the post-war liberal order, ensuring that economic rules are enforced and that national ambitions are subordinated to shared goals within multilateral bodies. But with the United States and China increasingly mixing economics with nationalist foreign-policy agendas, Europe will have to adapt.

By: Jean Pisani-Ferry Topic: Global Economics & Governance, Innovation & Competition Policy Date: April 3, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: China's place in the global trading system

Bruegel director Guntram Wolff and senior fellow André Sapir discuss how potential WTO reform could better accommodate China.

By: The Sound of Economics Topic: Global Economics & Governance Date: March 28, 2019
Read article More on this topic More by this author

Opinion

Takeaways from Xi Jinping’s visit to France and Italy and ideas for the EU-China summit

The author appraises China's strategy towards Europe ahead of next month's EU-China summit.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: March 27, 2019
Read about event

Past Event

Past Event

Changing relationships between Europe and Africa in the face of technological development – can digitalisation, AI and the platform economy help bridge the gap?

This event will look at digitalisation in Europe and Africa and how this is changing the relationship between the two continents

Speakers: Masood Ahmed, Charles Kenny, Susan Lund, J. Scott Marcus and Amolo Ng’weno Topic: Global Economics & Governance, Innovation & Competition Policy Location: 1 Abbey Gardens, Great College Street, London, SW1P 3SE Date: March 27, 2019
Load more posts