1. Rational Expectations Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

2. Adaptive Expectations The “natural rate” hypothesis of Phelps and Friedman is based on agents expectations of the future. The “natural rate” hypothesis of Phelps and Friedman is based on agents expectations of the future. Only when expectations are not realized is unemployment different than the natural rate of unemployment. Only when expectations are not realized is unemployment different than the natural rate of unemployment. During the time when expectations are not realized, agents make systematic errors in their decision-making. During the time when expectations are not realized, agents make systematic errors in their decision-making.

3. Importance of Expectations Subjective expectations are fundamental to behavior of agents in all economic activities. Subjective expectations are fundamental to behavior of agents in all economic activities. All actions are future-oriented. All actions are future-oriented. Expectations in Economics Expectations in Economics Keynes emphasis on uncertainty Keynes emphasis on uncertainty Shackle, Mises, Lachmann essays in 1930s concerning “elasticity of expectations” Shackle, Mises, Lachmann essays in 1930s concerning “elasticity of expectations”

4. Rational Expectations Tinbergen, “Ein Problem der Dynamik,” Zeitschrift fur Nationalökonomie, (1932). Tinbergen, “Ein Problem der Dynamik,” Zeitschrift fur Nationalökonomie, (1932). Walters, “Consistent Expectations, Distributed Lags and the Quantity Theory,” Economic Journal (June 1971). Walters, “Consistent Expectations, Distributed Lags and the Quantity Theory,” Economic Journal (June 1971). Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica, (July 1961). Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica, (July 1961). Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory (April 1972). Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory (April 1972).

5. Rational Expectations Basic argument: Agents will be forward-looking in their expectations, not backward-looking. While there is error-learning that does take place, expectations are not “adaptive.” Basic argument: Agents will be forward-looking in their expectations, not backward-looking. While there is error-learning that does take place, expectations are not “adaptive.” Muth: “expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.” Muth: “expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.”

6. Weak Version In forming expectations about the future value of a variable, economic agents make the best use of all publicly available information about factors they believe determine the variable.

7. Strong Version Economic agents’ subjective expectations of economic variables will coincide with the objective mathematical conditional expectations of those variables. X e t = E (X t | Ω t-1 )

8. What Ratex Are and Aren’t Rational expectations are not the same thing as perfect foresight Rational expectations are not the same thing as perfect foresight Agents make errors due to incomplete information Agents make errors due to incomplete information Rational expectations are correct on average Rational expectations are correct on average no systematic bias over time no systematic bias over time

9. What Ratex Are and Aren’t Strong version; X e t = X t + є t Strong version; X e t = X t + є t forecasting errors have mean = 0 forecasting errors have mean = 0 forecasting errors are serially uncorrelated forecasting errors are serially uncorrelated forecasting errors have lowest variance relative to any other method forecasting errors have lowest variance relative to any other method

10. Objections to Ratex Costs of acquiring and processing all publicly available information Costs of acquiring and processing all publicly available information Whether agents can learn true model of economy Whether agents can learn true model of economy The world is non-ergodic; each historical event is unique and non- repetitive. One cannot conceive of a probability distribution of unique events. The world is non-ergodic; each historical event is unique and non- repetitive. One cannot conceive of a probability distribution of unique events.

11. In defense of Ratex Does not require use of all information, but best use (equate marginal benefits and costs) Does not require use of all information, but best use (equate marginal benefits and costs) Does not require true model of economy – only that agents expectations are not systematically wrong (“as if”) Does not require true model of economy – only that agents expectations are not systematically wrong (“as if”) All business cycles share similarities; meaningful probability distributions can be estimated All business cycles share similarities; meaningful probability distributions can be estimated

12. Incentives for Ratex Agents wealth at stake Agents wealth at stake Adaptive expectations are serially correlated Adaptive expectations are serially correlated Uses current rather than past information Uses current rather than past information

13. Evidence for Ratex Expectations in survey data are influenced by age, geography, education and other variables Expectations in survey data are influenced by age, geography, education and other variables Weak direct econometric support Weak direct econometric support

14. Ergodicity and Institutions Davidson: Shackle’s crucial decisions and non-ergodicity of events in historical time Davidson: Shackle’s crucial decisions and non-ergodicity of events in historical time Leijonhufvud: Even if agents can form expectations rationally, the results of a monetary regime that is a “random walk” prevents the implications that are tied to Ratex from being realized Leijonhufvud: Even if agents can form expectations rationally, the results of a monetary regime that is a “random walk” prevents the implications that are tied to Ratex from being realized