John Cochrane has a superb publish discussing Bob Lucas’s contributions to macroeconomics. Right here’s some extent that I additionally maintain harping on:
The Fed typically asks economists for recommendation, “ought to we elevate the funds fee?” Submit Lucas macroeconomists reply that this isn’t a properly posed query. It’s like saying “ought to we cry wolf?” The appropriate query is, ought to we begin to observe a rule, a regime, ought to we create an establishment, that frequently and reliably raises rates of interest in a scenario like the present one? Selections don’t stay in isolation. They create expectations and reputations. For sure, this elementary actuality has not soaked in to coverage establishments. And that reply (which I’ve tried at Fed advisory conferences) results in glazed eyes. John Taylor’s rule has been making progress for 30 years attempting to bridge that conceptual hole, with some success.
Lucas is the economist that launched the rational expectations revolution. A lot of the skepticism about “rational expectations” comes from a scarcity of comprehension about what the idea really means. Right here’s Cochrane:
However “rational expectations” is basically only a humility situation. It says, don’t write fashions during which the predictions of the mannequin are totally different from the expectations within the mannequin. In the event you do, in case your mannequin is true, folks will learn the mannequin and catch on, and the mannequin gained’t work anymore. Don’t assume you economist (or Fed chair) are a lot much less behavioral than the folks in your mannequin. Don’t base coverage on an try and idiot the little peasants over and over. It doesn’t say that persons are large tremendous rational calculating machines. It simply says that they ultimately catch on.
I’d wish to illustrate the problem with a hypothetical instance involving a giant glass jar of jellybeans. You might recall a well-known instance cited within the “knowledge of crowds” literature, the place an MBA class was requested to estimate the variety of jellybeans in a big jar. Many of the guesses had been removed from actuality, however the median guess was surprisingly shut, say with 1% or 2%. In that case, how would I mannequin the general public’s jellybean estimates?
The least unhealthy strategy is perhaps to estimate the precise variety of jellybeans, after which assume that this determine was additionally the general public’s estimate. This strategy wouldn’t work completely, nevertheless it’s arduous to see any different that might be higher. Would you want to assume the common guess is simply 60% of the reality? How about 150%? If that’s the case, why?
Now suppose I ask a mathematician what number of ellipsoids with dimensions of 9 mm lengthy and 6 mm extensive will match right into a cylinder that’s 8 inches tall and has a diameter of 5 inches. The mathematician offers an equation that appears kind of sophisticated to the common particular person. Does it make sense to imagine that the common particular person makes use of that equation when estimating the variety of jellybeans? Clearly not. However that equation offers you an excellent estimate of the particular variety of jellybeans, and if now we have no motive to imagine the general public’s estimates are biased, then it additionally offers the most effective mannequin of the general public’s estimate.
Rational expectations fashions in macroeconomics are sometimes stuffed with scary wanting equations. The modeler then assumes that the general public’s forecast of variables comparable to inflation is “constant” with the mannequin. Thus if the mannequin predicts 7% inflation, we don’t assume that the general public forecasts 3% or 13% inflation—why would we? We assume that the general public additionally expects 7% inflation. That will not be appropriate, nevertheless it appears the least unhealthy strategy until now we have particular information that the general public both over or below estimates the variable in query. (Sadly, that is arduous to check, as inflation is poorly outlined. The general public’s estimates that present up in locations just like the Michigan survey most likely replicate a definition of inflation that doesn’t embrace hedonic changes, and thus is a bit larger than the federal government inflation estimate.)
Many individuals reject rational expectations as a result of it appears to recommend that the general public consists of tremendous clever calculating machines. However that’s under no circumstances what it means. Bennett McCallum urged that it will have been higher to name the idea “constant expectations”. The declare is definitely fairly modest. All of the rational expectations assumption says is that in case your mannequin particularly implies that X is true; don’t assume the general public believes that X is fake, at the very least not with out proof for that declare.