Last week, while I was going over the history of macroeconomic thought in class, I briefly discussed the concept of Rational Expectations and the place it occupied in the development of modern macroeconomics. In truth, I don’t spend a lot of time talking formally about rational expectations because it is simply part of the standard backdrop. That is to say, rational expectations (RE) models are not contentious anymore. This was not always the case. When rational expectations models were being developed in the 1960’s and early 1970’s it was a very foreign concept and was met with skepticism by mainstream macroeconomists. Today, rational expectations are the norm and are rarely discussed as a controversial part of the field. Outside of the economics profession, the idea that people possess something called rational expectations in the real world is often assumed to be wholly unrealistic and prima facie evidence that economic reasoning is useless and out of touch.

I’m going to use this post to discuss the meaning of rational expectations because (1) I think it is one of the most commonly misunderstood aspects of macroeconomics and (2) for the most part, rational expectations is essentially true in the real world – that is to say, most people actually have rational expectations.

The notion of rational expectations that I prefer (what I might call the weak-form of RE) goes something like this: People have rational expectations if their beliefs are consistent with the world they live in.

People hold lots of beliefs and these anticipations and expectations constantly influence their choices. For example, the exact time you leave for work in the morning might be influenced by your beliefs about when traffic is particularly heavy. When you leave might also depend on your beliefs about when the parking garage at work fills up. Your choice of restaurants might be influenced by how busy you think the restaurant will be, and so forth. The RE hypothesis says that these beliefs are consistent with the real world. If you think that your parking garage fills up by 8:45 am then you should not observe that the garage typically has empty spaces at 9:00. This is not to say that RE implies that your beliefs are perfectly correct. Expectational errors (or forecast errors) are perfectly consistent with the rational expectations hypothesis. For instance, if I roll two 6-sided dice, you will guess that the most likely number to get is 7. You will usually be wrong of course, but you won’t be systematically biased in your beliefs. It’s easy to find economic examples of RE as well. For example, if I tell you the economy is experiencing high unemployment and low inflation then you might guess that the Fed is more likely to cut the Federal funds rate rather than to raise it (assuming we aren’t at the zero lower bound of course). Again, the bond market traders could be surprised, but they shouldn’t be systematically surprised.

For this definition of rational expectations (the weak-form of RE), there is no need for individuals to understand why they observe the patterns they observe. They don’t need to know the model.

The examples I chose above are all cases in which RE works well. In these cases, RE is clearly the correct way to understand people’s actual beliefs and behavior based on those beliefs. Part of the reason these situations work well is that people have lots of experience with these situations. Everyone knows how to play the morning commuting game. Everyone knows how to play the restaurant game and so forth. We have repeated exposure to these situations and so beliefs which don’t fit with the real world will be punished and inevitably people will adopt “correct” beliefs. (It will take only a few days when you can’t find parking at 8:55 am before you revise your anticipations.)

Of course, there are situations when the rational expectations hypothesis is much less likely to hold. For example, we only play the marriage game one (or two or three) times. Hopefully we will only play the retirement game once. In these cases, we can’t rely on experience to discipline our beliefs and guarantee that our expectations will be rational. This doesn’t necessarily mean that RE isn’t a good assumption. We can still learn from the experiences of others; we can ask our friends or relatives what their experiences were like, and so forth.

The reason that RE is so common in macroeconomics is twofold. First, because much of macroeconomics concerns behavior which unfolds over time, anticipations and expectations inevitably influence current choices. As a result, macroeconomists have to make some assumption about where these beliefs come from. Second, while many situations might not be natural settings to trust a RE solution, RE is often a good benchmark.

One area in macroeconomics in which RE solutions are used often but in which we have good reason not to trust the solution concerns one-time unanticipated events. An investment tax subsidy should of course encourage investment but it should also influence the long-term payoff to capital. Forming expectations about this payoff requires investors to form accurate beliefs which extend far into the future. This seems like a hopeless case. The common solution (and the one I would use) is to invoke RE. This is convenient because it allows me to “fill in the blanks” and attach beliefs to future events but I’ll be the first to admit that this is a bit of a stretch. An even more difficult case might concern a policy for which we have little basis for comparison at all. The rapid extension of loan guarantees to financial intermediaries during the crisis surely had important effects on the market and surely behavior was conditioned to some extent by beliefs. I doubt these beliefs were anything resembling rational expectations though. My suspicion is that situations like this create confusion on the part of market participants. Unfortunately we don’t really have a good theory of confusion yet.

At its core, the rational expectations hypothesis says that your beliefs are not really your own. Your seemingly subjective and personal beliefs are influenced by the world you live in. In econ-lingo, your beliefs are endogenous.

Let me make one final comment. RE doesn’t really say anything directly about where your beliefs come from or how they are built up over time. If you move to a new city, you will gradually learn about the local commuting patterns and as you do so, your beliefs will converge to RE beliefs and your commuting choices will become more and more refined. Technically, RE assumes that the people in the model economy already have rational expectations. That is, RE doesn’t incorporate learning. Of course we have the ability to include learning but it is not too common in most models. There is of course the important issue of whether learning will actually lead to a RE equilibria. Usually it will – among the many important papers in one by Kalai and Lehrer (1993) which says that eventually RE will emerge provided that peoples’ initial beliefs possess a “grain of truth.”

(OK, I’m going to stop here, if I’m not careful I will go into full blown geek-out mode … )