Rational Expectations Revolution Research Articles

Overreaction and Diagnostic Expectations in Macroeconomics

We present the case for the centrality of overreaction in expectations for addressing important challenges in finance and macroeconomics. First, non-rational expectations by market participants can be measured and modeled in ways that address some of the key challenges posed by the rational expectations revolution, most importantly the idea that economic agents are forward-looking. Second, belief overreaction can account for many long-standing empirical puzzles in macro and finance, which emphasize the extreme volatility and boom-bust dynamics of key time series, such as stock prices, credit, and investment. Third, overreaction relies on psychology and is disciplined by survey data on expectations. This suggests that relaxing the assumption of rational expectations is a promising strategy, helps theory and evidence go together, and promises a unified view of a great deal of data.

The Engineering Tools That Shaped the Rational Expectations Revolution

The rational expectations revolution was not based only on the introduction of Muth’s idea of rational expectations to macroeconomics; this introduction alone cannot explain the more drastic changes to the mathematical toolbox, concepts, and research strategies since the 1980s. The shift from “Keynesian economics” to “new classical economics” is based on a shift from a control engineering approach to an information engineering methodology. This “revolution” was even more radical; it also changed the epistemology and ontology of macroeconomics. The ontology of information engineering, and hence of new classical economics, is a world populated by machines that communicate by the exchange of noisy information. The decisions these machines make are conditioned on the (noisy) information they have about the current state of the world but which at the same time will affect future states. Policy in this world therefore means tracing an optimal trajectory taking all these issues into account. To show this shift in epistemology and ontology, the history of economics is interwoven with the history of mathematics, which cannot be detangled from the emergence of the digital computer. The computer changed the nature of mathematics in a specific way by adopting a new concept of solution, namely the algorithm.

Seven Fallacies Concerning Milton Friedman's “The Role of Monetary Policy”

AbstractThis paper analyzes Milton Friedman's (1968a) article “The Role of Monetary Policy,” via a discussion of seven fallacies concerning the article. These fallacies are as follows: (i) “The Role of Monetary Policy” was Friedman's first public statement of the natural rate hypothesis. (ii) The Friedman–Phelps Phillips curve was already present in Samuelson and Solow's (1960) analysis. (iii) Friedman's specification of the Phillips curve was based on perfect competition and no nominal rigidities. (iv) Friedman's (1968a) account of monetary policy in the Great Depression contradicted the Monetary History’s version. (v) Friedman (1968a) stated that a monetary expansion will keep the unemployment rate and the real interest rate below their natural rates for two decades. (vi) The zero lower bound on nominal interest rates invalidates the natural rate hypothesis. (vii) Friedman's (1968a) treatment of an interest‐rate peg was refuted by the rational expectations revolution. The discussion lays out the reasons why each of these seven items is a fallacy and infers key aspects of the framework underlying Friedman's (1968a) analysis.

The Formation of Expectations, Inflation, and the Phillips Curve

This paper argues for a careful (re)consideration of the expectations formation process and a more systematic inclusion of real-time expectations through survey data in macroeconomic analyses. While the rational expectations revolution has allowed for great leaps in macroeconomic modeling, the surveyed empirical microevidence appears increasingly at odds with the full-information rational expectation assumption. We explore models of expectation formation that can potentially explain why and how survey data deviate from full-information rational expectations. Using the New Keynesian Phillips curve as an extensive case study, we demonstrate how incorporating survey data on inflation expectations can address a number of otherwise puzzling shortcomings that arise under the assumption of full-information rational expectations. (JEL D04, E24, E27, E31, E37)

Recent Developments in Macro-Econometric Modeling: Theory and Applications

Developments in macro-econometrics have been evolving since the aftermath of the Second World War.[...]

Seven Fallacies Concerning Milton Friedman's "The Role of Monetary Policy"

This paper analyzes Milton Friedman's (1968) article "The Role of Monetary Policy," via a discussion of seven fallacies concerning the article. These fallacies are: (1) "The Role of Monetary Policy" was Friedman’s first public statement of the natural rate hypothesis. (2) The Friedman-Phelps Phillips curve was already presented in Samuelson and Solow's (1960) analysis. (3) Friedman's specification of the Phillips curve was based on perfect competition and no nominal rigidities. (4) Friedman’s (1968) account of monetary policy in the Great Depression contradicted the Monetary History's version. (5) Friedman (1968) stated that a monetary expansion will keep the unemployment rate and the real interest rate below their natural rates for two decades. (6) The zero lower bound on nominal interest rates invalidates the natural rate hypothesis. (7) Friedman's (1968) treatment of an interest-rate peg was refuted by the rational expectations revolution. The discussion lays out the reasons why each of these seven items is a fallacy and infers key aspects of the framework underlying Friedman’s (1968) analysis.

Seven Fallacies Concerning Milton Friedman's 'The Role of Monetary Policy'

This paper analyzes Milton Friedman's (1968) article \The Role of Monetary Policy, via a discussion of seven fallacies concerning the article. These fallacies are: (1) \The Role of Monetary Policy was Friedman?s first public statement of the natural rate hypothesis. (2) The Friedman-Phelps Phillips curve was already presented in Samuelson and Solow's (1960) analysis. (3) Friedman's specification of the Phillips curve was based on perfect competition and no nominal rigidities. (4) Friedman?s (1968) account of monetary policy in the Great Depression contradicted the Monetary History's version. (5) Friedman (1968) stated that a monetary expansion will keep the unemployment rate and the real interest rate below their natural rates for two decades. (6) The zero lower bound on nominal interest rates invalidates the natural rate hypothesis. (7) Friedman's (1968) treatment of an interest-rate peg was refuted by the rational expectations revolution. The discussion lays out the reasons why each of these seven items is a fallacy and infers key aspects of the framework underlying Friedman?s (1968) analysis.

On Richard Goodwin’sElementary Economics from the Higher Standpoint

The aim of the article is to make an appraisal and an evaluation of Richard Goodwin’s Elementary Economics from the Higher Standpoint, a book which should be included amongst the few masterpieces of the economic literature of the past century, still much worth reading and studying for the fresh and relevant message it conveys. The book was published in 1970, 10 years after Sraffa’s Production of Commodities by Means of Commodities, and in a year in which a lively debate in capital theory between the two Cambridges was coming to a close. The first neoclassical synthesis was already accomplished, and signs of what later became the rational expectations revolution were beginning to be seen. The article brings to the fore the most significant aspects of Goodwin’s original contributions to economic analysis, which are magnificently disseminated throughout the whole book in a pedagogical though rigorous and refined exposition not yet surpassed.

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Book Reviews

Harold L. Cole of University of Pennsylvania reviews “How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies” by Roger E. A. Farmer. The EconLit Abstract of the reviewed work begins “Presents an introduction to macroeconomics for the general reader, examines the differences between the classical and Keynesian approaches, and considers policy solutions for the prevention of future financial crises. Discusses classical economics; the impact of John Maynard Keynes on the world economy; where the Keynesians lost their way; the rational expectations revolution; how central banks impact your life; why unemployment persists; why the stock market matters to us; whether there will be another Great Depression; whether monetary and fiscal policy will work; and how to solve a financial crisis. Farmer is Professor and Chair of the Economics Department at the University of California, Los Angeles. Glossary; bibliography; index.”

Animal spirits: how human psychology drives the economy, and why it matters for global capitalism

The global financial crisis has made it painfully clear that powerful psychological forces are imperiling the wealth of nations today. From blind faith in ever-rising housing prices to plummeting confidence in capital markets, are driving financial events worldwide. In this book, acclaimed economists George Akerlof and Robert Shiller challenge the economic wisdom that got us into this mess, and put forward a bold new vision that will transform economics and restore prosperity. Akerlof and Shiller reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery. Like Keynes, Akerlof and Shiller know that managing these animal spirits requires the steady hand of government--simply allowing markets to work won't do it. In rebuilding the case for a more robust, behaviorally informed Keynesianism, they detail the most pervasive effects of animal spirits in contemporary economic life--such as confidence, fear, bad faith, corruption, a concern for fairness, and the stories we tell ourselves about our economic fortunes--and show how Reaganomics, Thatcherism, and the rational expectations revolution failed to account for them. Animal Spirits offers a road map for reversing the financial misfortunes besetting us today. Read it and learn how leaders can channel animal spirits--the powerful forces of human psychology that are afoot in the world economy today.

In Honor of William Brainard and George Perry

THE BROOKINGS PAPERS ON ECONOMIC ACTIVITY is a unique and amazing institution, created by three visionaries, two of whom we thank and appreciate in this volume, George Perry and William Brainard. We should not, however, forget the founding contributions of Arthur Okun, who died in 1980, even though many readers know them only from the classic Brookings Papers of the 1970s, still full of wisdom. The Brookings Papers was much more unique at its inception in 1970 than it is today, because it has inspired imitation and because Okun and Perry were the first to understand the value of a field-oriented, ongoing, academic conference series. In the 1960s there were no conference series in economic specialties. One went to the annual American Economic Association meetings and the Econometric Society meetings and to department seminars, but nothing else. How did we survive? The fixtures of the macroeconomics conference circuit all started later: the Carnegie-Rochester series in 1973; the National Bureau of Economic Research's economic fluctuations program and its International Seminar on Macroeconomics and Summer Institute in 1978; the NBER Macroeconomics Annual in 1986 (a self-conscious copy of the Brookings Papers, I can say from firsthand knowledge); and the Minnesota Workshop in Macroeconomic Theory in 1990. The world was different in 1970, when the Brookings Panel first met. The Brookings special room rate at the Dupont Plaza for the first meeting was $14 a night. Central cities, including the Dupont Circle area of Washington, seemed doomed. For the first decade of the Panel's existence, we would not have dreamed of crossing the center of the circle after 6 p.m., and we could have bought a spectacular house in Kalorama for $25,000. I think some people feel that the Brookings Papers missed something in that two prominent developments in macroeconomics over the period of its existence--the rational expectations revolution and the simple general-equilibrium real business cycle model--did not figure prominently in the Panel's discussions. Or, to be more candid, they were more often criticized than advanced at the Panel. With respect to rational expectations, the editors did try to bring it within the Panel's ambit. Thomas Sargent, a leading proponent, was a member of the Panel in 1973 and wrote a significant Brookings Paper, (1) and Rudiger Dornbusch, who in 1976 became an instant star when he explained that rational expectations resulted in the overshooting of exchange rates, (2) was active here for many years. It did not take long for the Panel to follow the macroeconomics profession in absorbing rational expectations into its daily thinking. The Brookings Papers' hostility to the real business cycle model and its many progeny, the dynamic stochastic general-equilibrium models, is easier to explain and reflects well on the editors. When the panel was launched, big econometric models reigned over macroeconomics. The Brookings Institution had lent its name to a huge effort to produce one such model. But a strict founding principle of the Brookings Panel was no big models, and it would be hard to exaggerate how important this was for the intellectual contribution of the Brookings Papers. Big models were a dead end. I do not personally think that the smaller general-equilibrium models are a dead end, but it was an easy and understandable transition from hostility to the big models to hostility to the smaller ones when they sprang up from Minnesota. From the start the Brookings Papers was about sectors, equations, and phenomena, and not about general equilibrium. I think this was and is a great strength. In preparing these remarks, I went through the tables of contents of the Brookings Papers for its entire history--three issues a year in the first few years and two issues a year ever since, not counting the splinter publication, the Brookings Papers on Microeconomic Activity, which ran from 1989 to 1998. …

The Linearisation and Optimal Control of Large Non-Linear Rational Expectations Models by Persistent Excitation

Since the onset of the rational expectations revolution in macroeconomics some 30 or more years ago, a variety of techniques have evolved for the solution of rational expectations models. The first generation of methods were for linear models starting with the method of Blanchard and Kahn (1980). Because the models are large and usually non-linear, methods for solving (and optimising) such models have evolved in parallel (Holly and Zarrop, 1983; Finan and Tetlow, 1999; Fair, 2003). In contrast to recent methods that apply secon-order approximations (Schmitt-Grohe and Uribe, 2004; Sims, 2002b) in this paper we describe some computationally simple methods for linearising a non-linear model with rational expectations using persistent excitation. Each instrument, exogenous variable and expectational term is excited with a white noise process. Given superimposition, each input process is orthogonal so each equation can be estimated by OLS. Once the linear form is obtained and the time-consistent optimal feedback rule computed by dynamic programming, we apply the rational expectations solution of Anderson and Moore (1985) which is particularly suited when the leading structural matrix is singular. We apply the method to a nonlinear model of the UK Economy and report a series of impulse responses for output, inflation, the exchange rate and the short term interest rate.

AN INTERVIEW WITH THOMAS J. SARGENT

The rational expectations hypothesis swept through macroeconomics during the 1970s and permanently altered the landscape. It remains the prevailing paradigm in macroeconomics, and rational expectations is routinely used as the standard solution concept in both theoretical and applied macroeconomic modelling. The rational expectations hypothesis was initially formulated by John F. Muth Jr. in the early 1960s. Together with Robert Lucas Jr., Thomas (Tom) Sargent pioneered the rational expectations revolution in macroeconomics in the 1970s.

TOWARD AN ECONOMIC THEORY OF REALITY: AN INTERVIEW WITH GUILLERMO A. CALVO

Guillermo Calvo is one of the most influential economists in the field of international macroeconomics of the past 30 years. He has produced seminal articles in every area of macroeconomics and international economics that he has worked on, including his early classic articles on capacity utilization and time inconsistency, his 1980's works on efficiency wages, price stickiness, and policy credibility, and his recent studies on sudden stops and emerging market crises. Yet, the defining feature of Guillermo Calvo's contribution to our profession is not the depth and wide scope of the economic theories he has developed, but the central emphasis he puts in all his work on the role of economics as a tool for understanding reality and improving the quality of human life.Guillermo Calvo's passion for the policy implications of economic theory is obvious to anyone who has met him since his days as Senior Advisor of the Research Department of the IMF in the mid-1980's. This feature of his professional interests was much less obvious to those who interacted with him during his early years as an important figure of the rational expectations revolution. It was probably hard to see that behind the highly technical treatment presented in his articles at that time was an author who had his feet soundly set on the ground and focused on understanding how society could benefit from the renaissance of macroeconomic theory that was taking place. Interestingly, Michael Rothschild did figure out the true nature of Guillermo Calvo in those early years. When the University of California at San Diego tried to hire Calvo in the mid-1980's, Rothschild explained to Calvo that he was an excellent fit for San Diego because he was a particular type of theoretician: “Most theoreticians make theory out of theory,” Rothschild noted, but Calvo was different because he made “theory out of reality, taking what is really out there and presenting it in a much wider and complex form than a well-developed but narrow theory.”The following pages are excerpts from three interview sessions that Guillermo Calvo and I had at his office in the Inter-American Development Bank in the spring of 2003. These interviews provide a clear summary picture of Calvo as the theoretician of reality that Michael Rothschild described. The recollection of the conversation with Rothschild is one of many fascinating memories of Calvo's personal life and professional career that emerged during our meetings. We taped and transcribed the three meetings in Spanish and then Calvo and I together edited that material to produce this much shorter interview in English for Macroeconomic Dynamics.

The Concept of Real Economic Cycles and Its Role in Evolution of Macroeconomics

The article discusses the contribution of the 2004 Nobel Prize winners in Economics, F. Kydland and E. Prescott, to business cycle theory. To place this contribution in historical perspective, development of macroeconomic science at large, beginning with 1930, is discussed, including the early Keynesian theories, rational expectations revolution, and the modern debate between New Keynesians and New Classicals. Special emphasis is then made on the differences between the modern general equilibrium theories proposed by Kydland and Prescott and the supporters of theories based on sticky prices and imperfect information. The article is concluded by a discussion of room for consensus between these two branches of macroeconomics.

An Interview with Thomas J. Sargent

The rational expectations hypothesis swept through macroeconomics during the 1970's and permanently altered the landscape. It remains the prevailing paradigm in macroeconomics, and rational expectations is routinely used as the standard solution concept in both theoretical and applied macroeconomic modelling. The rational expectations hypothesis was initially formulated by John F. Muth Jr. in the early 1960s. Together with Robert Lucas Jr., Thomas (Tom) Sargent pioneered the rational expectations revolution in macroeconomics in the 1970s. We interviewed Tom Sargent for Macroeconomic Dynamics.

Origins and Consequences of Changes in U.S. Corporate Taxation, 1981-1998

foreign direct investment. hat U.S. corporate tax policy is partly determined by partisan and organizational forces as well as by domestic economic forces is a standard theoretical view. Scholars find that Democratic Presidential Administrations have differed from Republican Administrations in that the former tended to increase the tax burdens of corporate taxpayers. Other studies report that increasing business political activity has had an ameliorating effect on business tax burdens. On the economic side, corporate tax policy is counter-cyclical, investment inducing, and linked with growth and investment in long-run structural relationships. In at least two important ways, however, the structure of the American economy differed in the 1980s and 1990s from earlier periods. First, the U.S. economy internationalized, with the oil shocks of the 1970's serving as globalization's annunciation. Second, economic agents became increasingly sophisticated in anticipating how governments would respond to economic events and how these government policies would in turn affect economic events. The rational expectations revolution led President Reagan, among others, to conclude that traditional U.S. macroeconomic policies were ineffective. Some scholars argue that these structural shifts changed the dynamics of U.S. corporate tax policy. They theorize that, in open economies like the

Review of Sargent's The Conquest of American Inflation

Sargent's book provides a reinterpretation of the US inflation record over the last half-century, reflecting on how macroeconomic theory has evolved since the beginnings of the rational expectations revolution. It is a basic reference on dynamic macroeconomic theory.

Perfecting the Market's Knowledge of Monetary Policy

The rational expectations revolution made clear that a complete macro model requires a specification of the government's economic policy. We argue that monetary policy should be conducted in such a way that the market can predict policy actions. An implication of market success in predicting policy actions is that interest rates move ahead of the policy actions, and such a timing relationship may appear to some as the central bank following the market instead of leading it. Another implication of the market predicting policy actions is that nominal interest rate changes provide no useful information to the central bank about the strength of aggregate demand or inflationary expectations. Finally, failure of the market to predict policy actions reflects a problem that needs to be addressed.