Are employment decisions based on rational expectations?

Conventional employment functions with partial adjustment to output fitted to quarterly data tend to have positively autocorrelated residuals, to imply implausibly high returns to scale and almost always fail tests for parameter stability. The hypothesis of this paper is that mis-specified expectations are the main cause of these findings and rational and adaptive expectations models are compared. Further, employment is conditioned not on output but on variables which firms can more reasonably take as exogenous. ‘Disequilibrium’ features of labour markets are introduced by making adjustment costs depend upon current and expected labour market tightness.One of the implications of rational expectations is that the revision between points in time t and $\text{t ? 1}$ in the expected value of any variable should be independent of any information available before t and serially uncorrelated. Given a model of a forward looking firm whose hiring decisions are subject to quadratic adjustment costs, an appropriately transformed employment equation can be derived which has a very similar structure to the Koyck transformed employment equation which corresponds to adaptive expectations. Maximum likelihood estimation of the adaptive expectations form gives parameter estimates for quarterly British data for the manufacturing sector which are so unreasonable that this hypothesis can be rejected. Maximum likelihood estimation of the rational expectations form would involve modelling the stochastic processes of all the driving variables. However, conditional upon one parameter, consistent estimates of the remaining parameters can be obtained by OLS and these accord well with economic theory. This is the direct evidence in favour of the rational expectations hypothesis. However, it can also explain why the adaptive expectations form gives such poor results and why conventional employment functions give the unsatisfactory results referred to above. Further, rational expectations provides an explanation for the common finding, particularly in the context of employment and the demand for durable goods, of implausibly low or wrong signed levels effects in more general quarterly time series models with lagged dependent variables.