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Monday, October 17, 2011

Chow: Usefulness of Adaptive and Rational Expectations in Economics

Gregory Chow of Princeton on rational versus adaptive expectations:

Usefulness of Adaptive and Rational Expectations in Economics, by Gregory C. Chow: ...1. Evidence and statistical reason for supporting the adaptive expectations hypothesis ... Adaptive expectations and rational expectations are hypotheses concerning the formation of expectations which economists can adopt in the study of economic behavior. Since a substantial portion of the economic profession seems to have rejected the adaptive expectations hypothesis without sufficient reason I will provide strong econometric evidence and a statistical reason for its usefulness...
2. Insufficient evidence supporting the rational expectations hypothesis when it prevailed The popularity of the rational expectations hypothesis began with the critique of Lucas (1976) which claimed that existing macro econometric models of the time could not be used to evaluate effects of economic policy because the parameters of these econometric models would change when the government decision rule changed. A government decision rule is a part of the environment facing economic agents. When the rule changes, the environment changes and the behavior of economic agents who respond to the environment changes. Economists may disagree on the empirical relevance of this claim, e.g., by how much the parameters will change and to what extent government policies can be assumed to be decision rules rather than exogenous changes of a policy variable. The latter is illustrated by studies of the effects of monetary shocks on aggregate output and the price level using a VAR. Such qualifications aside, I accept the Lucas proposition for the purpose of the present discussion.
Then came the resolution of the Lucas critique. Assuming the Lucas critique to be valid, economists can build structural econometric models with structural parameters unchanged when a policy rule changes. Such a solution can be achieved by assuming rational expectations, together with some other modeling assumptions. I also accept this solution of the Lucas critique.
In the history of economic thought during the late 1970s, the economics profession (1) accepted the Lucas critique, (2) accepted the solution to the Lucas critique in which rational expectations is used and (3) rejected the adaptive expectations hypothesis possibly because the solution in (2) required the acceptance of the rational expectations hypothesis. Accepting (1) the Lucas critique and (2) a possible response to the Lucas critique by using rational expectations does not imply (3) that rational expectations is a good empirical economic hypothesis. There was insufficient evidence supporting the hypothesis of rational expectations when it was embraced by the economic profession in the late 1970s. This is not to say that the rational expectations hypothesis is empirically incorrect, as it has been shown to be a good hypothesis in many applications. The point is that the economic profession accepted this hypothesis for general application in the late 1970s without sufficient evidence.
3. Conclusions This paper has presented a statistical reason for the economic behavior as stated in the adaptive expectations hypothesis and strong econometric evidence supporting the adaptive expectations hypothesis. ... Secondly, this paper has pointed out that there was insufficient empirical evidence supporting the rational expectations hypothesis when the economics profession embraced it in the late 1970s. The profession accepted the Lucas (1976) critique and its possible resolution by estimating structural models under the assumption of rational expectations. But this does not justify the acceptance of rational expectations in place of adaptive expectations as better proxies for the psychological expectations that one wishes to model in the study of economic behavior. ...

    Posted by on Monday, October 17, 2011 at 09:54 AM in Academic Papers, Economics, Macroeconomics, Methodology | Permalink  Comments (3)


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