Comparing behavioural and rational expectations for the US post-war economy

The banking crisis has caused a resurgence of interest in behavioural models of expectations in macroeconomics. Here we evaluate behavioural and rational expectations econometrically in a New Keynesian framework, using US post-war data and the method of indirect inference. We find that after full reestimation the model with behavioural expectations is strongly rejected by the data, whereas the standard rational expectation version passes the tests by a substantial margin.     

Examining the role of expectations in a macromodel: Some results with the Finnish QMED model

This paper reports some policy experiments carried out with the QMED model of the Bank of Finland. The main issue in these experiments is the role of expectations. Thus, we compare an autoregressive expectations version with a rational expectations version of the model. When various policy simulations are carried out with these different versions – both in terms of anticipated and unanticipated shocks – it turns out that the whole short-run dynamics are crucially affected by the way in which expectations are modelled. In particular, we find the advance effects in the case of the rational expectations version can be of considerable magnitude.     

Encompassing and rational expectations: How sequential corroboration can imply refutation

Even though pieces of empirical evidence individually may corroborate an economic theory, their joint existence may refute that same theory. Testing of rational expectations models provides a concrete illustration of this principle. Surprisingly, empirical refutation of a rational expectations model may occur without having to estimate that model, and the refutation may be for a large class of expectations-based models and not just for a particular model specification. Narrow money demand in the United Kingdom illustrates such refutation. The general proposition concerning corroboration and refutation strongly favors the building of empirical models that are consistent with all available evidence. First version received: July 1994/final version received: July 1997     

ANTICIPATED UTILITY AND RATIONAL EXPECTATIONS AS APPROXIMATIONS OF BAYESIAN DECISION MAKING*

We study a Markov decision problem with unknown transition probabilities. We compute the exact Bayesian decision rule and compare it with two approximations. The first is an infinite‐history, rational‐expectations approximation that assumes that the decision maker knows the transition probabilities. The second is a version of Kreps' anticipated‐utility model in which decision makers update using Bayes' law but optimize in a way that is myopic with respect to their updating of probabilities. For several consumption‐smoothing examples, the anticipated‐utility approximation outperforms the rational expectations approximation. The rational expectations approximation misrepresents the market price of risk.     

Business cycle amplification with heterogeneous expectations

This paper studies the implications for business cycle dynamics of heterogeneous expectations in a stochastic growth model. The assumption of homogeneous, rational expectations is replaced with a heterogeneous expectations model where a fraction of agents hold rational expectations and the remaining fraction adopt parsimonious forecasting models that are, in equilibrium, optimal within a restricted class. Our approach nests the literature on rational expectations in business cycle models with a recent approach based on adaptive learning. We demonstrate that (i.) heterogeneous expectations can lead to substantial improvement in the internal propagation of equilibrium business cycle models and (ii.) the internal propagation depends on the degree of heterogeneity. A calibrated model with heterogeneity provides a closer fit to business cycle data than its representative agent, rational expectations counterpart.     

How useful are measured expectations in estimation and simulation of a conventional small New Keynesian macro model?

This paper examines how measured expectations (survey data) affect the basic properties of a conventional small New Keynesian macro model. In particular, how do survey expectations change the role of persistence of inflation and output (i.e. coefficients of the corresponding lagged terms)? Survey data are modeled in several different ways, to facilitate an analysis of different relationships with rational expectations. The model is estimated by means of a Bayesian estimator from quarterly euro area data using both aggregated and micro level data from the ECB Survey of Professional Forecasters for 1999Q1–2012Q3. The broad finding is that the use of measured expectations produces more economically meaningful results than does the standard use of model-consistent rational expectations. In particular, survey expectations also reduce the relative weights of the lagged dependent variables in the Phillips curve and the IS curve. All this shows up in impulse responses that turn out to be quite different suggesting that measured expectations are not only proxies of rational expectations. By contrast, measured expectations are related to rational expectations with a way that may well reflect different adjustment and learning processes.     

Money demand, the Cagan model, testing rational expectations vs adaptive expectations: The case of Turkey

This paper estimates the Cagan type demand for money function for Turkish economy during the period 1986:1–1995:3 and tests whether Cagan's specification fits the Turkish data using an econometric technique assuming that forecasting errors are stationary. This paper also tests the hypothesis that monetary policy was implemented in aiming to maximize the inflation tax revenue. Finally, the Cagan model is estimated with the additional assumption of rational expectations for Turkey for the considered period. First version received: March 1998/final version received: October 1998     

Modelling the business cycle of a small open economy: The Reserve Bank of New Zealand's DSGE model

We describe the underlying structure of the new forecast and policy model used at the Reserve Bank of New Zealand and evaluate its ability to explain New Zealand data. Unlike other estimated small-open-economy DSGE models, we find that more than one third of the domestic GDP growth is driven by foreign shocks. The elevated contribution of foreign shocks to the domestic economy is driven by our decision to exclude mapping export demand to data on world GDP. Estimating our model without any foreign demand data limits the response of exports to the real exchange variations. This feature makes exports and, consequently, domestic GDP much more sensitive to variations to foreign demand and raises the importance of foreign shocks to the domestic business cycle. Furthermore, our analysis suggests that a model with “adaptive” expectations is preferred by the data relative to the version of the model with “rational” expectations. In that case, the model explains nominal variables using on average much smaller shocks.     

Accommodation,supply shocks,and sluggish real wages

This paper analyzes the policy dilemmas posed by supply shocks in a rational expectations model featuring sluggish real wages. A discrete time version of the model is used to calculate the variances for prices, wages, and output for alternative policy rules and speeds of adjustment for real wages. The conventional tradeoffs between output and price variability in the model do not always exist.     

Heterogeneous expectations,indeterminacy, and postwar US business cycles

This paper estimates a New Keynesian model extended to include heterogeneous expectations: consumers and firms form either rational or boundedly-rational expectations. The inclusion of heterogeneous expectations alters the determinacy properties of the model, with the details of expectations potentially becoming more influential than the Taylor principle for equilibrium stability.The model is estimated with Bayesian techniques, using rolling windows and allowing the parameters to fall both in the determinacy and indeterminacy regions. The estimates reveal large shares of agents who depart from rational expectations. Heterogeneous expectations are decisively preferred by the data everywhere in the sample.Finally, the paper revisits the narrative that sees postwar US macroeconomic data as consistent with indeterminacy in the pre-1979 sample, with a switch to determinacy starting in the early 1980s, and it shows that it is overall robust to inclusion of heterogeneous expectations.     

Can people learn rational expectations?

In this note the stability of the rational expectations equilibrium for the Foster and Frierman (1990) version of the Blume and Easley (1982) model is investigated under the assumption that the learning mechanism used by economic agents is based on a selection mechanism on a class of competing models having a physical meaning for the agent and not on the interpolation of models having no clear physical meaning, as it is often the case in the literature on learning rational expectations. It is found that, under the standard assumption that the rational expectations model is in the information set of the uninformed trader no matter his degree of rationality, convergence to it is less likely the higher the uninformed agent's degree of rationality, in a sense to be specified in the paper. Some comments on the result are also provided.     

The demand for money during a period of inflationary expectations. Some FIML based estimates for Greece

This paper estimates and tests a model of the demand for money function, which uses the public's expectations of future inflation as a proxy of the opportunity cost of holding money. The hallmark of the paper is that expectations are rational inMuth sense. The cross-equation rational expectations restrictions are derived and then tested, using quarterly Greek data of the high inflation period 1973I to 1981 IV. The paper concludes that the evidence is consistent with the rational expectations assumption and supports the adopted specification of the money demand function.     

An intertemporal system of dynamic consumer demand functions

This paper constructs and estimates a system of dynamic consumer demand equations under the assumption of rational expectations about anticipated human wealth. The traditional one-period budget constraint is replaced by the lifetime anticipated wealth constraint. Lagged dependent variables are rationalized by an adjustment cost argument. In the model presented, both the dynamic adjustment coefficients as well as the parameters characterizing the underlying long-run preferences are identified and can be estimated. We find that a weak version of the REH cannot be rejected on the data. In common with most empirical studies on demand behaviour we have to reject the symmetry restrictions.     

Rational expectations and fixed-event forecasts: An application to UK inflation

This paper tests a version of the rational expectations hypothesis using ‘fixed-event’ inflation forecasts for the UK. Fixed-event forecasts consist of a panel of forecasts for a set of outturns of a series at varying horizons prior to each outturn. The forecasts are the prediction of fund managers surveyed by Merrill Lynch. Fixed-event forecasts allow tests for whether expectations are unbiased in a similar fashion to the rest of the literature. But they also permit the conduct of particular tests of forecast efficiency - whether the forecasts make best use of available information - that are not possible with rolling-event data. We find evidence of a positive bias in inflation expectations. Evidence for inefficiency is much less clear cut.First version received: June 2002/ Final version received: November 2003We would like two anonymous referees and an editor for comments that have significantly improved the paper. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank of England.     

JAPAN: THE CASE FOR A TAYLOR RULE? A SIMPLE APPROACH

Abstract.  In this article I propose two different models for analyzing the conduct of monetary policy, facing certain expectations. The first is a autoregressive model, which implicitly accounts for adaptive expectations, while the second accounts for the rational expectations. I used these models to judge whether or not the Taylor rule can be a good benchmark for the conduct of monetary policy in Japan. The conclusion is that a simple AR model fits the data better than the Taylor rule, and that assuming rational expectations in Japan could be highly misleading, at least since the mid-1990s.     

Rational Expectations is not Generally Valid for Econometric Models: Evidence from Stock Market Data

In applying the rational expectations hypothesis to generate expectations in an econometric model it is assumed that (1) the model itself is capable of generating reasonable forecasts of all required expectations variables included in the model, and that (2) the economic agents whose behavior is being modeled act as if they form their psychological expectations as conditional mathematical expectations generated by the model. Both assumptions can be invalid, as demonstrated by the historical data on Hong Kong stock prices and by the successful application of the adaptive expectations hypothesis to explain panel data of prices of individual stocks and aggregate time series data on stock price indices of the United States and of Hong Kong.     

A Note on Aggregation and the Lucas Critique

The paper investigates the effects of aggregation on different macroeconomic modelling strategies. This is done within the framework of a small example economy, where all households solve the same intertemporal consumption problem, but with different parameters of the utility functions and different exogenous income processes. Three models are fitted to the aggregate data: a representative agent rational expectations model, a simple version of the permanent income hypothesis, and a time series model. If the economic environment is kept stable, the three approaches perform similarly well. However, the representative agent model stands up to the Lucas critique better than its competitors, despite the aggregation error. Unlike the other models, it never gives completely wrong forecasts even after an exogenous change in income processes.     

Markov-switching models,rational expectations and the term structure of interest rates

In order to evaluate the efficiency of the monetary transmission mechanism, we develop the formulas for testing rational expectations theory in the term structure of interest rates with VAR models of stochastically switching regimes in which all the parameters are regime dependent. These formulas are obtained for the strict version of rational expectations as well as for the case where measurement errors are assumed in the expectations relationship. They are extensible to other contexts that involve variables linked by rational-expectations behaviours. The testing procedure is implemented on interest rates of the Spanish inter-bank money market. Measurement errors must be assumed to find signs favourable to the theory.     

Unemployment and econometric learning

We apply well-known results of the econometric learning literature to the Mortensen and Pissarides real business cycle model. Agents can always learn the unique rational expectations equilibrium (REE), for all possible well-defined sets of parameter values, by using the minimum-state-variable solution to the model and decreasing gain learning. From this perspective the assumption of rational expectations in the model could be seen as reasonable. But using a parametrisation with UK data, simulations show that the speed of convergence to the REE is slow. This type of learning dampens the cyclical response of unemployment to small structural shocks.     

Information at equilibrium

Summary. In a game with rational expectations, individuals simultaneously refine their information with the information revealed by the strategies of other individuals. At a Nash equilibrium of a game with rational expectations, the information of individuals is essentially symmetric: the same profile of strategies is also an equilibrium of a game with symmetric information; and strategies are common knowledge. If each player has a veto act, which yields a minimum payoff that no other profile of strategies attains, then the veto profile is the only Nash equilibrium, and it is is an equilibrium with rational expectations and essentially symmetric information; which accounts for the impossibility of speculation. Received: June 20, 2001; revised version: January 9, 2002 RID="*" ID="*" We wish to thank Pierpaolo Battigalli, Fran?oise Forges, Franco Donzelli, Leonidas Koutsougeras, Aldo Rustichini, Rajiv Vohra and Nicholas Yannelis for their comments. Correspondence to: H. Polemarchakis