Rational Expectations

Transcription

1 Rational Expectations

2 RATIONAL EXPECTATIONS Macroeconomics for the 1980s? Michael Carter The Australian National University and Rodney Maddock The Australian National University M MACMILLAN

3 Michael Carter and Rodney Maddock 1984 All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any means, without permission First published 1984 by Higher and Further Education Division MACMILLAN PUBLISHERS LTD London and Basingstoke Companies and representatives throughout the world British Library Cataloguing in Publication Data Carter, Michael Rational expectations 1. Macroeconomics I. Title II. Maddock, Rodney 339 HB ISBN DOI / ISBN (ebook)

4 To Jenny, Chris and Juan

5 Contents Preface x1 Introduction TheoryDevelopment Theory and Society Conclusion 10 Expectations in Economics What are Expectations? The Cobweb Model Extrapolative Expectations Adaptive Expectations Rational Expectations Conclusion 35 Appendix: Some Topics from Probability Theory 36 Random variables and expectations 36 Stochastic processes 39 Demand Policies to Reduce Unemployment The Tools of Macroeconomic Policy Aggregate Demand and Supply The Slope of the Aggregate Supply Curve 51 Workers are fooled 58 Money wages are inflexible 60 vii

6 viii Contents The Natural Rate of Unemployment Inflation and Expectations EconomicTargetsandthePolicyRule Conclusion 77 Appendix: The Phillips Curve 79 Rational Expectations: the Challenge to Policy The Model Solving the Model The Policy Rule Would Adaptive Expectations make any Difference? Conclusion 101 The Counter-Attack Rational Expectations are too Implausible 105 Individuals are rational 106 The honest government argument 110 All profit opportunities will be exploited 110 Only a subset need be rational 111 No competing theories Learning to be Rational The Economic Model is Wrong 114 Continuous market clearing 115 Non-treatment of capital 117 Persistence 118 Does the World Fit the Models? DirectTests 123 Unbiasedness 123 Efficiency 125 Conclusion The Output-Inflation Trade-off Testing the Natural Rate Hypothesis Testing the Combined Hypotheses Response to Failure Only Unanticipated Policy Matters Conclusion 141

7 Contents ix 7 Looking Backward and Looking Forward HowhasEconomicsChanged? Have Rational Expectations Theorists Succeeded on their Own Terms? Conclusion 156 References 158 Author Index 162 Subject Index 164

8 Preface Once again, macroeconomics is at the forefront of economic debate. Theory and practice are pursued with a vigour not seen since the Great Depression and the days of Keynes. If there is a single focal point of the modern debate, then it is surely rational expectations. The theory of rational expectations was presented to the economics profession as a rationale for its own impotence. A deceptively simple concept, its implications appeared at first to be radical and profound. With the passage of time, a more secure analysis of the impact of rationality is now emerging. The rational expectations revolution has highlighted some of the shortcomings of the orthodox Keynesian synthesis which guided economic policy through the 1950s and 1960s. But has it provided a better alternative theory to guide policy in the 1980s? Our book seeks to answer this question. It does not purport to be a comprehensive survey of all that has been written on the subject of rational expectations. That task has been undertaken by others. Nor, certainly, does it claim to be an authoritative and ultimate assessment of an era in economic thought. Our book has much more modest objectives. We have aimed to set out the central ideas of rational expectations in a macroeconomic context in a manner which we hope is accessible to beginning students. We also hope that it will prove of value to those non-professionals with some background in economics who are mystified by the intellectual basis of current macroeconomic xi

9 xii Preface policy. Much of the literature on rational expectations is abstruse in the extreme. Our task has been to present the essence of this work in a simple and coherent fashion. Wherever necessary, we have not hesitated to substitute clarity for rigour. We encourage the reader who is curious about the finer points to consult the original journal articles. Indeed, a subsidiary aim of this book is to equip the motivated reader to tackle the journal literature. There is a strong theme underlying our book - namely, that economic research does not proceed serendipitously like the drunk's random walk. Rather, the direction of economic research responds to the state of the world. Rational expectations came along when it did because of the demonstrated failure of preexisting theory to explain the dismal economic performance of the period. But economic researchers also tend to act like the drunk who looks for his car key under the light of the lamp-post rather than in the dark where he dropped it. They like to cling to familiar territory, they are reluctant to abandon a line of research even if there is mounting evidence that the key is not to be found there. There is a tendency to focus on problems which are tractable though less relevant. These characteristics of economic research are evident in the story of rational expectations. Indeed, we believe that the development of the theory becomes much clearer if it is viewed from the perspective of an evolving research programme. We have highlighted this methodological perspective and organised our presentation in historical fashion. Methodologists will recognise a strong Lakatosian (Lakatos, 1970) flavour. This makes the development of rational expectations more transparent. In addition to its intrinsic interest, the story of rational expectations is of interest as a case study in the development of economic thought. We hope that the book might be useful supplementary reading for courses in economic methodology or the history of economic thought. The book traces its heritage to a well-received article published in the Journal of Economic Literature (Maddock and Carter, 1982). Readers of that article might wonder what has happened to Bert and Ernie. We can assure you that they are alive and well and have not given up arguing with one another about the world of economics. However, we felt that they had reached their limit in this particular topic. A more conventional presentation was better suited to a book-length exposition. Naturally, the book covers a

10 Preface xiii lot more ground than the article and reflects, we hope, the development of our own understanding in the intervening time. Nevertheless, the article still offers an entertaining introduction to some of the main issues canvassed in this book. We have one significant apology to make- to our friends who work within the post-keynesian and radical economics traditions. Such scholars have made a number of powerful and important criticisms of the macroeconomic approach discussed in this book. These include the nature of capital, the complete uncertainty of the future, the role of institutions, of time and of history. Rational expectations theorists have taken little notice of these questions. Thus it has not been necessary for us to dwell on these issues and we have been able to develop our story within the theoretical framework provided by the neoclassical synthesis. By omitting reference to these criticisms which arise outside the rational expectations research programme, we do not mean to imply that they are unimportant or inconsequential. Rather, we judge that they have not played a significant role in the development of the rational expectations programme so far and therefore fall outside the scope of this book. Every author is only too well aware that he or she cannot write a book alone. Our own debts are many and we can only single out a few for special mention. We have benefited of course from help and encouragement from our colleagues, especially Jeff Borland, Malcolm Gray, Fred Gruen, Ian McLean, Nils Olekalns and Adrian Pagan. Jenny Anderssen, Cherie Cromwell, Eva Klug and Doug Whaite, always willing and competent, provided invaluable research assistance. The fine environment and facilities provided by the Institute of Advanced Studies at the Australian National University have greatly facilitated our work. Finally, we wish to acknowledge the role of our wives, Colleen and Marleny, without whose warm support and understanding little would have been achieved. We have made a determined effort to write this work in a non-sexist manner. Since established habits are very hard to overcome, even this goal is probably less than perfectly achieved. For this and all shortcomings of this book, we of course assume full responsibility. Michael Carter Rodney Maddock