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The Problem with Rational Expectations in Macro

By Tom W. Bell and Glen Whitman

I'm not much of a macroeconomist, which is why I haven't had much to say about the current financial crisis and recession. But I did have to take the standard macro courses in grad school, and I remember having one major methodological objection to the rational-expectations models we were learning at the time. Arnold Kling nails it:

Economist X has one model of the economy. Economist Y has another model of the economy. In X's model, people believe in X's theory. In Y's model, people believe in Y's theory. It is logically impossible for economist X and economist Y to inhabit the same universe! Yet they do. This tells me that the axiom of rational expectations is too strong.

Exactly. But notice that this is not a criticism of the rationality assumption. Nor is it a criticism of incorporating expectations into an economic model. Neither component of the label "rational expectations" was the problem. The real problem was the additional assumption, rarely stated explicitly but applied repeatedly when solving the models mathematically, that all economic actors shared the economist's model of the world. And that's manifestly false if even economists don't all share the same model.

I sometimes wonder (idly, with no intention of doing the research to find out) if any macroeconomist has constructed a model in which the modeled agents make rational decisions based on assumptions that differ from those of the model.

Full post as published by Agoraphilia on March 11, 2009 (boomark / email).