Rational Vs Adaptive Exectations
I really shouldn’t comment on Simon Wren_lewis’s defence of rational expectations until I have calmed down, but I can’t help muself. I will try to stick to FRED, that is data.
Wren-Lewis argues that it is reasonable for macroeconomists to assume rational expectations since the practical alternatives are rational expectations or naive expectations.
However most of the time macroeconomists want to focus on something else, and so we need a simpler framework. In practice that seems to me to involve a binary choice. Either we assume that agents are very naive, and adopt something very simple like adaptive expectations (inflation tomorrow will be based on current and past inflation), or we assume rational expectations. My suspicion is that heterodox economists, when they do practical macroeconomics, adopt the assumption that expectations are naive, if they exist at all (e.g. here). So I want to explain why, most of the time, this is the wrong choice. My argument here is similar but complementary to a recent piece by Mark Thoma on rational expectations.
Suppose we have an equation determining wage or price inflation (a Phillips curve), where inflation expectations appear on the right hand side of the equation. We need some way of determining those expectations. Lots of nice words like ‘non-ergodic’ will not do: we need something simple that can be used to solve the model. To assume, as mainstream macroeconomists once did, that these expectations just depend on past observations about inflation seems to assume that agents are stupid. These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession.
I will assume for the sake of argument that this is true. I think it is obvous that it is better to assume adaptive than rational expectaions when attempting to model advanced industrial economies and to guide policy.
I note that the assumption of naive expectations leads to the belief that there will be irrational speculative bubbles in which agents assume some asset price will increase because it has in the past. This is one of they key features of the data. It is possible to reconcile this witih the rational expectations assumption, because anything at all can be reconciled with the assumption (note I never assert that the rational expectations hypothesis is false since we all agree that there is no falsifiable rational expectations hypothesis).
The rational expectations assumption convinced policy makers in the early 80s that disinflation would not be costly provided that iron resolve etc gave the dry policy credibility. It was exceedingly costly.
But mostly I think that the rational vs adaptive expectations debate can best be addressed just by looking at a bit of data which is not decisive but, to me, convincing on the order of the anthropogenic global warming debate.
I ask Provessor Wren-Lewis how often he looks at a graph like the one below (made at FRED). I am askkng for information and I hope to get an answer.
The blue curve is inflation expected by ordinary people from the Michigan Survey, the red curve is cpi inflation in the yer till the date of the survey and the green line is core inflation (CPI minus food and energy). It seems to me that survey expected inflation is equal to CPI inflation except when CPI infation is extraordinarily different from core inflation because of a recent Iraqi invasion of Iran or theh 2008 collapse of demand for, among other things, petroleum. This simple ad hoc model CPI or core if very different fits the data rather well. I would say its empricial success is vastly greater than the empirical success of any micro founded macro model..I note that my model is much more naive than the paleo-Keynesian approach. Adaptive expectations are a weighted sum of the old expected inflation and lagged actual inflation. They smooth off peaks as in 1980 and early 2009. The blue curve looks like the red curve smoothed is a pretty good summary of data all of which was collected *after* rational expectations assumption was declared the winner of the debate.
Thre is another anomaly. In recent years Michigan survey forecast inflation is persistently higher than actual inflation. At the same time the general public’s estimates of achieved inflation are higher than official calculations. The rational expectations assumption has very strong implications for statements about data available at the time the statement was made. These implications are totally rejected by the data.
OK back to Wren-Lewis’s critique of the adaptive expectations hypothesis
“These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession” Most economic agents in the USA clearly ignore what economists and the media say about inflation in the past few years. This is plainly true. Wren Lewis knows it is true (he wrote so in another post). So why is it better to assume that people read, here *an believe* something when they insist that they don’t ? Not acceptable as a useful approximation but necessary no matter how well another approaach fits the data. How about shifts in monetary policy. Do you think anyone who didn’t know when monetary policy shifted could figure out the dates by contrasting the blue and red lines ? Is there any hint of a trace of evidence in the data that a huge tightening of monetary policy causes expected inflation to be lower than one would guess using only lagged inflation ? I ure don’t see it. And the behavior in recessions is completely different in different recessionss.
All of WRen-Lewis’s question are easily answered with the most cursory glance at the relevant data. The answer, as always for developed countries, is that the evidemce supports the assumption of adaptive expectations.
Now this doesn’t mean that it is reasonable to assume adaptive expectations when considering hyperinflation. Long ag a macroeconomist correctly noted that there aren’t simple patterns relating real and nominal variables and, in particular, everything is close to neoclassical in the case of hyperinflation. Long ago means 1936 and the economist is Keynes. I am. as usual araphrasing The General Theory… If a macroeconomist suggested in 1968 that this was a new insight, then he was lying.
OK post too long. I have tried to avoid being rude (really) and see an earlier post for more recent data supporting the adaptive expectations hypothesis.
Here’s a question I asked Wren-Lewis but didn’t get a response. Either my question was idiotic or there really isn’t a good answer.
Isn;t adaptive expectations a property of the *aggregate*? Assuming AE assumes nothing about the behaviour of individuals. So the claim that AE assumes agents are stupid, is stupid. Is the fallacy of composition so deeply entrenched in macroeconomists’ thinking that they are unable to even imagine that the individual and aggregate can behave in ways that are very different? It is entirely possible that some individuals do indeed have ‘adaptive expectations’, but it is not necessary. AE is a simple heuristic for capturing the inertia in the behaviour of aggregates . How the behaviour of diverse agents, heterogeneous along multiple dimensions, aggregates to inertia in the aggregate is an important but separate question.
Another surprising part of SW-L’s post was that he uses a PC, of all things, to point to the superiority of RE. My understanding was that the PC is a clear example of the superiority of AE over RE. Despite Jordi Gali’s best efforts, the NKPC remains an empirical embarrassment, and the other RE based PC, SIPC (Mankiw and Reiss, 2002) doesn’t work well either.
“The rational expectations assumption convinced policy makers in the early 80s that disinflation would not be costly provided that iron resolve etc gave the dry policy credibility. It was exceedingly costly. ”
Sargent, in his hyperinflations paper, put this as a definitive test of RE vs AE. It was a clear and deeply embarrassing loss for RE, and the faithful switched to the ‘No True Scotsman’ defense. Why this wasn’t a knockout blow for RE is something I’ve never understood.
Rational expectations seems to require a great deal of economic rationalization along with much spouting of ideological cant and flouting of the evidence. Only an economist could take it seriously.
oh my I am about to defend the rational expectations assumption. Agreed it is not anywhere close to true. The reason I think it can be ok to make it is to focus on something other han expectations on tastes technology institutions or soething. It is a way to close models. I assume this and that and i assume the agents in my model make the same assumptions. It helps to have a standard default assumption so people can tell that different models have different implications for soe reaso other than different assumptions about expectations. Rational expectations is one assumption. Adaptive expectations isn’t — you still have to make more choices after deciding to assume adaptive expectations.
Note however that I a talking about clarifying thought — ab academic discussion. I don’t see any case for basing policy on models with rational expectations and I see lots of damage all around me caused by people who did.
I think RE is a truly bizarre modeling strategy.
Expectations do not have to be adaptive – you might very well model them as forward looking – but the question about how expectations are formed cannot be up to the particular economist or, more precisely, up to the particular economists particular model (since the same economist will claim that inflation expectations are formed in a very different way in all his/her other models).
I do not say that there has to be one single way to model it, and that everyone has to agree on that model – but would it not be enough with a few perspectives, each containing a few alternatives? If a particular economist did not want to study expectation formations him-/herself, (s)he could choose the formulation (s)he found most convincing – but not simply propose his/her own crackpot theory as it was the most normal thing in the world to do (which it, amazingly enough, is under the current regime).
Since there are infinitely many economic models, and no one thinks a single one of them provides more than, at best, insights – it is, at least to me, quite obvious that something like the formation of inflation expectations should be independent of how one of many models created by one of many economists suggests inflation actually happens.
As one with no dog in this hunt, I will comment on the tone of the post. Didn’t seem rude at all to me, or even shrill. Could have been written by Sergeant Friday (as in “Just the facts, ma’am.”)
From a very no economist with experience in chemical kinetics and a bit of life the stickiness of expectations is large. Expectations are formed by previous experience. When very bad things happen people become very cautious for a very long time. The 1930s depression lasted in the people who experienced it until they died. The inflation of the 1970s dominated peoples expectation well into the 1990s, etc. And you do remember irrational expectations of the boom years?
Pick your stickiness parameter and you have your model.