Are macroeconomic models just politics in drag? ]]>

Absolutely awesome. I have been laughing for 10 minutes and just hope I never write something that merits Glasner’s criticism. And I had been worried that economists had no sense of humor. I am so happy I read to the end of your responses there. Thank you David Glasner. ]]>

Nick (1), You said:

“I can have rational expectations, and update my expectation rationally when new information comes in.”

I agree, but given the information available, there is only one rational expectation which is the equilibrium price vector that would obtain conditional on the available information. If the information changes, the equilibrium price vector changes and so would the rational expectation.

“My rational expectation can be different from your rational expectation, if I have different information from you.”

My information and your information cannot be true simultaneously. So if there are information differences, there cannot be a rational expectation, because at least one (and probably both) of us will turn out to be wrong.

“In both cases the expectations will be probabilistic; I won’t (rationally) hold any belief with certainty, if I know I don’t have full information.”

If people have, and act on, different information, their expectations can’t be rational, because their expectations will necessarily be disappointed. Given their expectations, there is no possible state of the world in which the expectations of anyone are realized. The fixed point property of the model – that when agents expect the equilibrium price vector their expectations are (or could be) validated — can’t hold.

“Game theorists don’t bother calling it “rational expectations”. They talk about Bayes-Nash (or something) equilibrium.”

Good for the game theorists, but they are talking about an equilibrium in which each agent assumes that other agents will adopt an optimal strategy, so that their expectations are consistent in a certain sense. Here we are talking about an underlying inconsistency in expectations that makes it inevitable that expectations are disappointed and then have to be revised.

david w, That may be how some people interpret rational expectations, but I don’t understand what kind of mechanism could possibly operate to cause the average expectation to be rational. That is pure hand-waving. The supposed gain in realism doesn’t make the model more realistic, it’s a cosmetic concession, but it undermines the basic logic of the rational expectations method. Rational expectations should be thought of as a check on the internal consistency of a model, not as an empirical statement about the world.

Nick (2) You said:

“that sounds more like perfect foresight, which is only the same as rational expectations under full information.”

It’s not perfect foresight, because I don’t rule out the possibility that everyone’s expectations are wrong. I am just saying that their expectations are consistent, so that there is some possible state of the world in which their expectations could be realized. If expectations are inconsistent, there is no possible state of the world in which anyone’s expectations are realized. Even if the expectations of some people are realized, their expectations are not rational because the actual price vector that validates their expectations is not an equilibrium price vector, but rational expectations are defined in terms of the equilibrium price vector. If everyone expects the equilibrium set of prices, then, as long as there is no exogenous change invalidating the information on which they based their expectations, their expectations will be realized.

“Lucas 72 for example is a rational expectations temporary equilibrium model where agents don’t have full information (they can’t distinguish real from nominal shocks), and so get surprised about next period’s price level.”

Lucas 72 was a failure which is why Kydland and Prescott invented RBC theory. But they just made a bad situation worse. Much worse!

Philip, There is no reason in principle why the situation you are talking about could not be taken into account by any of the standard models, but to do so they would have to acknowledge that people act on different information and that the expectations on which they base their decisions is often very much mistaken. An economy can continue to function fairly efficiently within a certain range of error, but when expectations are too far off, the economy gets into trouble and the adjustment to past mistakes becomes very messy.

Henry, You asked:

”How can there be rational expectations if expectations are modified by new information?”

Expectations are rational if they are mutually consistent and could be realized in some possible state of the world. If it turns out that the actual state of the world is different from the state of the world that would have allowed those expectations to be realized, the expectations were rational, but they were incorrect.

Greg, No, it’s all very simple really.

JKH, Thanks. Obviously, I agree with your assessment of what I wrote and I share your impatience with the modeling strategy that has taken over macroeconomics.

Srini, Thanks and thanks for the links.

Unlearningecon, Thanks. I don’t agree that we can make any statement about the transition from one equilibrium path to another. The transition is terra incognita. Usually the assumption is that the new information is processed and there is an immediate jump from one path to the other. If you try to model the transition, you get into all the difficulties associated with the inconsistency between rational expectationse and learning, not to mention the intractable problems associated with trading at disequilibrum prices.

I am Responding to Idiots, Thanks. Your indulgence is truly Trumpian in its humility and magnanimity.

]]>Comment on David Glasner on ‘Rational Expectations, or, The Road to Incoherence’

A paradigm is defined by its axioms. Orthodox economics is built upon this set of foundational hard core propositions: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985)

The representative economist has not realized it but methodologically these premises are forever unacceptable. It should be pretty obvious that the neo-Walrasian hard core contains THREE NONENTITIES: (i) constrained optimization (HC2), (ii) rational expectations (HC4), (iii) equilibrium (HC5).

Nowadays, all scientists agree that angels, phlogiston, epicycles, superman, and the Easter Bunny are nonentities. As far as economics is concerned we can agree that utility, constrained optimization, intertemporal optimization, rational expectation, well-behaved production functions or supply-demand-equilibrium are nonentities just like the Easter Bunny. Every model that contains a nonentity is A PRIORI false. In practical terms: as soon a the word equilibrium/disequilibrium appears in an economic paper it can be thrown into the waste basket. The same holds for all other nonentities.

The discussion of models that contain nonentities is vacuous. Nick Rowe, J. W. Mason and David Glasner resemble medieval witch hunters who exchange their opinions about the difference between incubus and succubus.

Rethinking economics means to discard the failed paradigms and to fully replace Walrasian microfoundations and Keynes’s flawed macrofoundations by something new which has to be entirely FREE of nonentities. As Romer has recognized, with DSGE economics has hit the wall at the end of the blind alley.

Egmont Kakarot-Handtke

]]>There are a couple of similar issues that have always bothered me about macro models. I am entirely willing to admit that these may just be my misunderstandings and am happy to be corrected. As Greg has pointed out, this stuff is just confusing.

– When you solve the transition path of a macro model after a shock, it is in steady state equilibrium at every point in the transition. So when does the adjustment actually take place?

– You solve a model before a shock, which gives you the (steady state) maximisers of an infinite summation. Then after some t<inf, there is a shock. You now solve the model from 0 to infinity after the shock. But shouldn't we be looking at what happens at time t, given that the model has been 'running' for t periods prior to the shock? Would the relevant variables necessarily be at their steady state values values at time t? Does solving from 0 to infinity both times and speaking of the 'transition' between them really make sense?

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