Notes on solving linearized rational expectations models eric sims university of notre dame spring 2014 1 introduction the solution of many discrete time dynamic economic models is a system of nonlinear di erence equations. Thus, it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. I will rst introduce the idea of rational expectations and describe how to solve and simulate linear rational expecations models that have both backward and forwardlooking components. Practically all the recent work applying rationalexpectations models to macro theory has been concerned with the phillipscurve questions raised by friedman, phelps, lucas, and others, but the macro implications of. The eu wants common regulations to make it easier to trade. For any square matrix w, w 1awis a so called similarity transformation of a. Rational expectations, the lucas critique and the optimal. Rational expectations theory definition investopedia. As wrenlewis 2007 states, two later developments have completed the microfoundations of macroeconomics. Rational expectations has incorporated anything known at t1 with implications for y at time t into the expected part, so that the unexpected part is purely unpredictable. It is not a debate about rational expectations in the abstract, but about a choice. Building on rational expectations concepts introduced by the american. Rational expectations rational expectations economic.
Rational expectations ensure internal consistency in models involving uncertainty. We discuss its compatibility with two strands of karl popper. Rational expectations models in macroeconomics john b. Rational expectations in the macro model brookings papers on economic activity, 1976, no. Rational expectations and the new classical macroeconomics f. Karl whelan ucd models with rational expectations spring 2016 4 36. In the ny times, nobel laureate robert schiller, explains the impact of rising home prices. Theory of rational expectations economics britannica. Pigou even anticipated the concept of rational expectations by noting that rational. Macroeconomic analysis without the rational expectations.
Throughout, it remained critical of the antiempirical drift encouraged in the lucas critique, criticism borne out more recently by the financial instability of the 1990s and the crisis that followed. The dsge approach relies on the idea that people have socalled rational expectations. Admittedly, during the recession it dropped into the negative ranges for 5 year forecasts, but, after the recession when we still had high unemployment inflation expectations were around 2%. Comment on reform and revolution in macroeconomics your summary of what lucas said or meant about keynesianism and what keynesians commented on rational expectations reminds one of the definition of scholarship. Notes on solving linearized rational expectations models eric sims university of notre dame spring 2017 1 introduction the solution of many discrete time dynamic economic models is a system of nonlinear di erence equations. Along the way, we will 1 discuss budget constraints and wealth accumulation. Fixed exchange rates, more on monetary policy tutorial 7. Nber working paper series rational expectations and macroeconomic forecasts victor zarnowitz. Rational expectations 319 distributed random variables 8t with zero mean and variance a2. Revolution and evolution in twentiethcentury macroeconomics. Comment on the day macroeconomics changed the council of nicaea repudiated arianism and adopted the original nicene creed. Mainstream macroeconomics has incorporated some aspects of monetarism and rational expectations theory. However, the idea was not widely used in macroeconomics until the new classical revolution of the early 1970s, popularized by robert lucas and t. Persistence of high inflation and high unemployment, federal.
Especially investment decisions are subject to the second type of. Rational expectation is the focal point of the modern debate in economic theory. Theory of rational expectation theories macroeconomics. He focuses on the multiplicity question that arises in infinite horizon rational expectation models and considers the implications for a theory of endogenous fluctuations. This is principally because of a recent reaction against the theoretical. He focuses on the multiplicity question that arises in infinite horizon rational expectation models and considers the implications for a theory of. In economics, rational expectations are modelconsistent expectations, in that agents inside the model are assumed to know the model and on average take the models predictions as valid.
They incorporated increasingly sophisticated dynamics and attracted the efforts of the best economists. Start studying macroeconch17disputes over macro theory and policy. One method for approximating the solution to these models is by loglinearizing the. Wallis 1995 reports that as methods of estimating rational. Macroeconomic models were influential, big, and econometrically advanced. Practically all the recent work applying rational expectations models to macro theory has been concerned with the phillipscurve questions raised by friedman, phelps, lucas, and others, but the macro implications of.
It was similar to jumping from the wright brothers to an airbus 380 in one generation. The rational expectations hypothesis scielo colombia. In this book roger guesnerie contributes to the critical assessment of the rational expectations hypothesis reh. Micro, meso a nd macro are levels or scales that can and may be mobilised in social analysis. Similarity transformations has the property that they do not change the eigenvalues of a matrix, so t. Roger guesnerie contributes to the critical assessment of the rational expectations hypothesis reh. Building on rational expectations concepts introduced by the american economist john muth, lucas. The pioneer is the one proposed by blanchard and kahn 1980. Macroeconch17disputes over macro theory and policy. The rational expectations hypothesis levy economics institute.
Fixed exchange rates, more on monetary policy pdf tutorial 7. To obtain consistency within a model, the predictions of future values of economically relevant variables. The work of sargent and wallace 1975 was significantly influential not only for its profound contribution to the policy ineffectiveness debate but for illustrating the case where the solutions to macro econometric models with rational expectations could be substantially. Rational expectations rational expectations is a building block for the random walk or efficient markets theory of securities prices, the theory of the dynamics of hyperinflations, the permanent income and lifecycle theories of consumption, and the design of economic stabilization policies. Common macro factors and currency premia ilias filippouand mark p. Adaptation of macro theory to rational expectations. In the early 1970s the american economist robert lucas developed what came to be known as the lucas critique of both monetarist and keynesian theories of the business cycle. Rational expectations theory an economic idea that the people in the economy make choices based on their rational outlook, available information and past experiences. Supply side shocks, rational expectations, exchange rate dynamics tutorial 6. The real business cycle theory rbc introduced the idea that macroeconomic models should be microfounded, i. How the rational expectations revolution has enriched stanford. Re becomes more acceptable if it is viewed as a possible ideal limit point for the expectations of boundedly rational agents with limited information who engage in learning in successive. The rational expectations hypothesis reh is the standard approach to expectations formation in macroeconomics.
Equating coe cients on the lhs and the rhs we get a a. Start studying macro econch17disputes over macro theory and policy. Thus it is important to distinguish between individual and market expectations. Solution methods for rational expectations models having described econometric methods for measuring the shocks that hit the macroeconomy and their dynamic e. I was interested to see that michael woodford, in his defence of microfoundations methodology here, nevertheless pinpoints rational expectations as a key weakness, and learning models as the way forward.
Note that y t is labour income income earned from working not total income because total income also includes the capital income earned. Generally, it was assumed that agents used some simple extrapolative rule whereby the. But they were thought to be serviceable approximations, especially when they yielded good fits in estimated models. Solving linear rational expectations models 5 equations 0. Rational expectations does borrow heavily from other books bill has written, but there is enough new stuff in there to keep even old hands interested. The theory of rational expectations re is a collection of assumptions regarding the manner. Hopefully models of learning will eventually allow expectations errors to be analysed in a more plausible, systematic and routine way.
This paper is intended as a popular summary of some recent work on rational expectations and macroeconomic policy and was originally prepared for a conference on that topic at the federal reserve bank of minneapolis in october 1974. For an early argument that rational market reactions may coexist with a large amount of individual irrationality, see becker, 1962. Macroeconomic analysis without the rational expectations hypothesis. Rational expectations and econometric practice book description. New classical macro economics dates from the 1970s, and is an attempt to explain macro economic problems and issues using microeconomic concepts like rational behaviour, and rational expectations. Solving linear rational expectations models 3 where tis at least upper block triangular t 2 4 t 11 t 12 0 t 22 3 5 1. Submissions tenuously related to economics, light on economic analysis, or from perspectives. New classical economics is associated with the work of chicago economist, robert lucas. If i can read a few chapters of this book starting at 7 am after a night shift in a completely darkened room without falling asleep, thats some real. Morgan, the history of econometric ideas, cambridge. No doubt, the theory of rational expectations is a major breakthrough in macroeconomics. Learn vocabulary, terms, and more with flashcards, games, and other study tools.
Rational expectations, the media and politics as those of you who have read a few of my posts will know, on the occasion that i venture into political science i like to push the idea that the attitudes and organisation of the media are an important part of trying to understand the political dynamic today. A particular keystone for that development was, of course, kydland and prescott. Economics schools of thought economics online economics. And while rational expectations is a clear baseline, once one moves away from it. To counterpoise sovereignty as an alternative perspective to economics misses an important point. Rational expectations is a building block for the random walk or efficient markets theory of securities prices, the theory of the dynamics of hyperinflations, the permanent income and lifecycle theories of consumption, and the design of economic stabilization policies. Clearly, for others the specification of concepts that have been unacceptable ab initio is not such a memorable event.
Rational expectations and the theory of economic policy. But rational expectations requires one to be explicit about the full limitations of peoples knowledge and exactly what kind of mistakes they make. The household budget constraint let a t be household assets, y t be labour income, and c t stand for consumption spending. The rational expectations revolution highlighted some of the shortcomings of the orthodox keynesian synthesiswhich governed economic policy during the 1950s and 1960s. Third, rational expectations remain as a consistency axiom wrenlewis, 2007, in the sense that they are capable of being reconciled with different theoretical structures arestis and sawyer, 1994. Introductory notes on rational expectations 1 overview. Prior to the 1970s, this aspect of macro theory was largely ad hoc. Defending rational expectations whenever i post anything which suggests that the idea of rational expectations was a useful innovation in macroeconomics, lars syll writes something to the effect that i am and therefore most mainstream macroeconomists are so wrong, so wrong. Solving dynamic rational expectations models franck portier based on gilles saintpaul lecture notes franck. The idea of rational expectations was first discussed by john f. Oct 26, 20 rational expectations, the media and politics as those of you who have read a few of my posts will know, on the occasion that i venture into political science i like to push the idea that the attitudes and organisation of the media are an important part of trying to understand the political dynamic today. The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences. A comprehensive collection of readings published in the literature on rational expectactions in macroeconomics, including sargents classical macroeconomic model as well as the original papers by muth that started the rational expectations literature. Solving models with rational expectations karl whelan.
As my next door neighbour in the department at oxford. Pdf micro, meso and macro levels of social analysis. First, we show that the reh is utterly incompatible with the former. But the measure of market inflation expectations breakeven inflation has been anchored around 2% since the end of the recession. The theory suggests that the current expectations in the economy are equivalent to what the future state of the economy will be. This work was motivated mainly by the prospect of obtaining useful tools for practical forecasting, but it is increasingly recognized that the data can have.
Other articles where theory of rational expectations is discussed. Rational expectations in the macro model brookings. As an economist, i naturally focus on the economic aspects of the eu. The rational expectations hypothesis was first developed as a theoretical technique. Rational expectations theory defines this kind of expectations as being the best guess of the future the optimal forecast that uses all available information. Here, we will look at the question of how a consumer with rational expectations will plan their spending over a lifetime. Each belief system redefines itself from time to time and orthodox economics is no exception. Notes on solving linearized rational expectations models eric sims university of notre dame spring 2015 1 introduction the solution of many discrete time dynamic economic models is a system of nonlinear di erence equations. Rational expectations and the theory of price movements. Jul 31, 2015 rational expectations does borrow heavily from other books bill has written, but there is enough new stuff in there to keep even old hands interested.
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