Saturday, August 22, 2015

Noah Smith — A great critique of Rational Expectations

So why does everyone and their dog use Rational Expectations? Manski says that, basically, it's because A) it's easy, and B) there's no obviously better alternative:
Another part of the reason must be the data used in empirical research. As illustrated in Section 2, choice data do not necessarily enable one to infer the expectations that decision makers hold. Hence, researchers who are uncomfortable with rational expectations assumptions can do no better than invoke some other unsubstantiated assumption. Rather than speculate on how expectations actually are formed, they follow convention and assume rational expectations.
I'd add a third, more cynical reason: Rational Expectations can't be challenged on data grounds. If you measure expectations with surveys, people can poke holes not just in your theoretical model, but in the expectations data that you gathered and the econometric methods that you used to extract a signal from it. But if you assume Rational Expectations, they can only poke holes in the model itself. Basically, substituting theoretical assumptions for empirical results makes a model a more hardened target. If it makes the model less able to fit the data at the end of the day, well..."all models are wrong", right?

Anyway, everyone should go read Manzi's entire paper. Very interesting stuff, even if a decade old.
Why do economists so often assume that they and the decision makers they study share rational expectations? Part of the reason may be the elegant manner in which these assumptions close an economic model. A researcher specifies his own vision of how the economy works, and he assumes that the persons who populate the economy share this vision. This is tidy and self-gratifying.
A great critique of Rational Expectations
Noah Smith | Assistant Professor of Finance, Stony Brook University


Random said...

Rational Expectations is completely insane. Total irrational.

Random said...
This an oldie but a goldie. Take into account hidden wealth and property. But then spending is progressive (I think!)

Anonymous said...

Not to mention that "Rational Man" would require an observer. An observer that might just be as crazy as a peach orchard boar.