Rational Expectations
Source Jim Devine
Date 07/12/12/22:46

(1) the neoclassical (and neoRicardian) economic notion of
"equilibrium" as actually attained does have its use. The main use is
to test the internal consistency of an economic model.

For example, back in the 1970s, Robert Lucas and his colleagues
advanced Muth's notion of "rational" expectations (RatEx) as an
important logic-check for macroeconomic models.

For the uninitiated, RatEx does _not_ represent a case of rational
calculation (by homo economicus), balancing the costs and benefits of
collecting and using information, about what to expect about the
future. Rather, it involves the assumption that "agents" (that's us)
have an identical model of how the economy works -- eerily and
inexplicably identical to the one held by the macroeconomist -- and
then use that model in order to crank out what to expect. (Because
everyone has exactly the same model of the economy, merge the entire
population into a single "representative agent.")

As an economist at Cal Tech (name forgotten) pointed out at a seminar
I went to, this is the macro-equivalent of the Game Theorist's Nash
equilibrium. In macro, these expectations are not assumed to be
correct, however, since the fact of incomplete information is
introduced by introducing random error around correct expectations.
(This seems akin to the idea of "trembles" in Game Theory.)

To sketch an example, initially ignore the random aspect. Because the
macroeconomist uses a monetarist/classical model, the representative
agent has one too -- and thus concludes that if the money supply is
growing at 10% per year, the potential real GDP is increasing at 3%
per year, and the velocity of money is constant, the inflation rate
will be 7% per year. (The monetarist/classical model bizarrely assumes
that in a non-random world, actual GDP always equals potential, under
Say's "Law.") The agent then acts on this expectation, raising its
price by 7%. The economist's model -- which predicted 7% -- is
totally consistent with the agent's actions. Expectations are in
equilibrium: what's real is rational and what's rational is real.

On the other hand, if the agent simply adapts its expectations to
experience with past inflation (following what's variously called
"adaptive expectations," "partial adjustment," or "Bayesian
learning"), it may easily expect an inflation rate that's completely
inconsistent with the model: if the growth rate of the money supply,
that of potential, and that of velocity, all stay constant, the
agent's expected inflation rate will _never_ equal the actual
inflation rate. The only exception occurs when the initial expectation
equals 7%.

Bringing in the random element, the representative agent using RatEx
will not have correct or equilibrium expectations. But it will be
correct on average.

(2) So the idea of equilibrium -- here of expectations -- makes the
model consistent, unlike the case of adaptive expectations, in which
history (experience) plays the major role.

The problem is that it's not the internal consistency of the model
that's important. What's important is the consistency of the model
with empirical reality. On the latter score, the RatEx story has
failed miserably, being rejected by even the most conservative
macroeconomists. Its stock is sinking even for those studying
financial markets (where it appears as part of the "efficient markets

If we reject the RatEx theory, we have to accept the idea that
expectations are never in equilibrium, consistent with reality. That's
because we live in a world where historical time prevails (in which
the present is simply a moment in the movement from the irreversible
past to the unknowable future) rather than the purely logical time
that microeconomists and RatEx people love. Adaptive expectations may
not be correct, but since the economy is always changing, our guesses
about the future will like jump from being too high to too low and
back again.

Further, expectations have an impact on the so-called objective
reality which RatEx theory assumes is given and immutable. That is,
banks can fail due to self-fulfilling prophecies. A recession can
happen because the state of long-term capitalist profit expectations
goes sour. Etc.

The real world is never in equilibrium, except perhaps in local cases.
So there's no reason to privilege the equilibrium concept.

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