Professional Documents
Culture Documents
ational Expectations
f Macroeconomics*
t Fans of the National Football League may well have observed the
t following behavior by the Houston Oilcrs during the 19-- season. At
liome against Kansas City, when confronted with a fourth down in its
,:&g ond of ths ficld. Houston punted 100 perccnt of the time. The
aext weck, at St. LOUIS, ln thc samc altua:ion. Houaton punted 0.1
perccnt of the time. The following week at Oakland, again in that
1 situation, Houston again punted 100 percent of the time, as it did the
: subsequent week at home against San Diego, and so on and on for the
i .t of the season. In short, on the basis of thc time-series data, Hous&&n has a tendency to punt on fourth downs in its own territory, no
ti what team it plays or where.
kaving observed this historical record, suppose it is our task to
ct how Houston will behave in the future on fourth downs in its
&vn territory. For example, suppose that next week Houston is to play
!@ expansion team at Portland that it has never played before. It seems
to predict that Houston will punt on fourth downs in its own
s chapter is baed on remarks preparad for t%e Scpkmter
of the Hosei University
in Tokyo. lapan.
1980 Intemational
RATIONAL
EXPECTATIONS
AND
MACROECONOMICS
territory at Portland. This sensible prediction is not based on any understanding of the game of football, but rather on simply extrapolating
a past behavior pattem into the future.
In many cases, we would expect this method of predictton to
work well. However, for precisely those cases in which predictions
are most interesting, the extrapolative method can be expected to
break down. For example, suppose that the commisdoner of the National Football League announced a rule change, effective next Sunday, that gave a team six downs in which to make a first down. Would
we still expect Houston to punt on fourth down? Clearly not; at least
no one familiar with the game of football would.
What this example demonstrates is that historical pattems of human behavior often depend on the rules of the game in which people
are participating. Since much human behavior is purposeful, it makes
sense to expcct that it will change to take advantage of changes in the
rules. This principie is so familiar to fans of football and other sports
that it hardly bears mentioning. However, in the context of economic
policy the principie very much deserves mentioning bccause here it
has bccn routincly ignorcd-and with some devastating results. Adhcrcnts of thc thcory of rational expectarions belicve, in fact. that the
tield of macroeconomics must be reconstructed in order to take account of this ptinciple of human behaviot. Their effotts to do that
involvc busic changcs In thc ways e~ontu111~tt1for~~~uhttc,nl~aul~~te. nad
predict with econometric models. They also call for substantial
changes in the ways economic policymakers frame their options.
MODELS
SHOULD
WITH THE RULES
LET BEHAVIOR
OF THE GAME
CHANGE
CHANQE
rates, and portfolios as functions of variables that summarixe the information people use to make those decisions. For al1 of their mathematical sophistication. econometric models amount to statistical devices for organizing and detecting pattems in the past behavior of
peoples decision making, pattems that can then be used as a basis for
predicting their future behavior.
As devices for extrapolating future behavior from the past under
a given set of rules of the game, or govemment policies, these models
appear to have petformed we11.4They have not performed well, however, when the rules changed. In formulating advice for policymakers,
economists have routinely used these models to predict the consequences of historically unprecedented, hypothetical govemment interventions that can only be described as changes in the rules of the
game. Ln effect, the models have been manipulated in a way that
amounts to assuming that peoples pattems of behavior do not depend
on those properties of the environment that govemment interventions
would change. The assumption has been that people will act under the
new rules just as they have under the old, so that even under new
rules, past behavior is still a reliable guide to future behavior. Econometric models used in this wuy have not been nble to predict accurately the consequences of histotically unpardfleled interventions. To
take one recent example, standard Keynesian and monetarist econotnetric nttdeln huilt In the lata 19fOn fallad ta prodict tho cffocto nn
output, employment, and prices that were assoclatec! wlth the unprecedented large deficits and rates of money creation of the 1970s.
Recent research has been directed at building econometric models that take into account that peoples behavior pattems will vary
systematicrdly with changes in govemment policies-the
rules of the
game.6 Most of this research has been conducted by adherents of the
so-called hypothesis of rational expectations. They model people as \
making decisions in dynamic settings in the face of well-defined constraints. Included arnong these constraints are laws of motion over
time that describe such things as the taxes people must pay and the
ptices of the goods they buy and sell. The hypothesis of rational expectations is that people understand these laws of motion. The aim of
the research is to build models that can predict how peoples behavior
will change when they are confronted with well-understood changes in
--_
FIATIONAL EXPECTATIONS
AND h4ACl?OECONOMICS
ways of administering taxes, govemment purchases, aspects of monetary policy. and the like.
Example
1: The Investment
Declslon
A simple example will illustrate both the principie that decision rules
depend on the laws of motion that agents face and the extent that
standard macroeconomic models have violated this principie. L-et k, be
the capital stock of an industry and 7, be a tax rate on capital. Let T,
be the first element of z,, a vector of current and lagged variables,
including those that the govemment considers when it sets the tax rate
on capital. We have r,=erz,, whem e is the unit vector with unity in
the first place and zeros elsewhere. Let a firms optimal accumulation
plan require that capital acquisitions obey
m
k, = hk,-,
- ar~tiE,~,+~
i-0
n>O.O<h<
I.O<S<
(1.1)
where E,r, +j is the tax rate at time r that is expected to prevail at time
f + j.
lkp~utlon 1, I cupturca thc notltw lhat tha dasmd for cnpltnl roy
sponds negatively to current and future tax rates. However, equation
1.1 does not become an operational investment schedule oc decision
rule until we specify how agents views about the future, E,T,+~, are
formed. Let us suppose that the actual law of motion for z, is
Zr+ I = AZ,
(1.2)
- 6A) - z,
(1.3)
MODELS
.--,.
- .---_
CHANGE
_ __
heyday of Keynesian macroeconomics in the 1960s. This is not unusual, for the innovation of rational expectations reasoning is much
more in the ways equations are interpreted and manipulated to make
statements about economic policy than in the look of the equations
that are fit. Indeed, the similarity of standard and rational expectations
equations suggests what can be shown to be true generally: The rat@ral. expectations
reconstruction
macroeconom&
isnotx
... ^.. _-.: ..,.;-. of ----
directed at improving the stahsbcal fits of Keynesian
or monetarist
-..._-.---_
macrocconomic models over give? histor$
periods_and
-_--that_-its suc-
cess or failure cannot be judged by .cornp-&rg &e R;g. of--,-reconstructed macroeconomic models with those of models constructed and
interpreted along earlier lines.
Under the rational expectations assumption, the investment
schedule (equation 1.3) and the laws of motion for the tax rate and
the variables that help predict it (equation 1.2) have a common set of
parameters, namely, those of the matrix A. These parameters appear
in the investment schedule because they influente agents expectations
of how future tax rates will affect capital. Futher, notice that al1 of the
vnriahles in z, nppenr in the invcstment schedule. since via equation
1.2 all of these variables help ngents forecast future tax rates. (Compare this with the common econometric practice of using only current
and lagpcd values of the tax rate as pmxies for exptcted futun tax
rates.)
The fact that equations 1.2 and 1.3 share a common set of parameters (the A matrix) reflects the principie that firms optima1 decision rule for accumulating capital, described as a function of current
and lagged state and information variables, will depend on the constraints (or laws of motion) that flrms face. That is, the firms pattem
l
of investment behavior will respond systematically to the rules of the
game for setting the tax rate 7,. A widely understood change in the
policy for administering the tax rate can be represented as a change in
the first row of the A matrix. Any such change in the tax rate regime
or policy will thus result in a change in the investment schedule (equation 1.3). The dependence of the coefficients of the investment schedule on the environmental parameters in matrix A is reasonable and
readily explicable as a reflection of the principie that agents rules of
behavior change when they encounter changes in the environment in
the form of new laws of motion for variables that constrain them.
i
--
RATIONAL
EXPECTATIONS
ANO
MACAOECONOMICS
MODELS
where
h. = - a/(l
+ h,,~,
(1.4)
- 6)
where now
h, = - a/(l
LET
Example
CHANGE
2: Are Government
Deflclts
Inflatlonary?
A second example that well illustrates our general principles about the
interdepcndence of the strategic behavior of private agents and the
govemment concems the inflationary effects of govemment deficits.
We can discuss this matter with the aid of a demand function for base
money of the specific form
(1.5)
M
-=a
Pt
Here the investment schedule itself changes as the policy for setting
the tax rate changes.
Standard econometric practice has not acknowledged that this
sort of thing happens. Retuming to the more general investment example, the usual econometric practice has been roughly as follows.
Iliria. n modcl in ~ypically specificd and estimated of the form
+ ht,
EEHAVIOA
adopting more sophisticated and more general lag distributions for the
vector h. as perhaps was hoped in the 1960s.
+ 6)
k, = Xk,-,
SHOULD
(1.6)
wbere
I -a*&s
a, B a* > 0
t Pr
(1.7)
E,M,+,
(21
(1.8)
RATIONAL
EXPECTATIONS
G, - T, = Mr p>-
AND
MACROECONOMICS
+ E, - (1 + r,_,)B,_,
r,-, 2 0
where
MODELS
(1.9)
For simplicity, equation 1.9 assumes that all govemment interest-bearing debt is one period in maturity. Equation 1.9 must hold for all
periods t. Again for simplicity, we shall also think of equations 1.8
and 1.9 as applying to an economy with no growth in population or
technical change.
Under the system formed by equations 1.8 and 1.9, the intlation\
! ary consequences of govemment deficits depend sensitively on the
govemments strategy for servicing the debt that it issues. We consider
lirsl a ntrict Ricnrdinn rcgime in which government deficits have no
clleck4 on 1l1.2lilk OI illlhlli~m. In 1his rcgilllc. IllC ~,vcrlllncllt Illwllyfl
finances its entire deticit or surplus by issuing or retiring interest-bear; ing govemment debt. This regime can be characterized by either of
! the foollowing two equations, which are equivalent in view of equalion
I .9:
M, - M,-, = 0
B, = Et 2 Rti
(Tt+j+l
- G,+j+t)
(1.10)
(1.11)
j=O
where
R, = A (1 + r,+J
i=O
/ Equation 1.10 states that the supply of base money is always constant,
1while equation 1. ll states that the real value of govemment debt
; equals the present value of prospective govemment surpluses. In this
j regime a positive value of interest-bearing government debt signals a
,! stream of future govemment budgets that is in surplus in the present
value sense of equation 1.11. Increases in govemment debt are temporary in a sense made precise in equation 1.11.
SHOULD
LET
SEHAVIOR
CHANGE
for all 2
(1.12)
G, - T, = Mr ,-
I
IIb bis
ltllc~. tlrlicls IIIC IIIWIIYR ttr hr flnnncetl cntircly hy
issuing additional base money, with interest-bearing government deb
never being issued. In this regime, the time path of govemment defi
cits allccts the time path of the price levo1 In a rigid and immodiat
way that is described by equations 1.8 and 1.13. Under this regime i
10
1
!,:
:/i
RATIONAL
EXPECTATIONS
AND
MACROECONOMICS
IMPLICATIONS
ll
OF THE EXAMPLES
These two examples illustrate the general presumption that the systematic bchavior of privatc agents and thc random bchnvior of markct
outcomcs both will chanpc whcncvcr agents constraints change, as
when govemment policy or other par& of the environment change. To
make reliable statements about policy interventions, we need dynamic
models and econometric procedures that are consistent with this general presumption. Foremost, we need a new and stricter definition of
the class of parameters that can be regarded as srrucrural. The body
of doctrine associated with the simultaneous equations model in
econometrics properly directs the attention of the researcher beyond
reduced-form parameters to the parameters of structural equations that
are meant to describe those aspects of peoples behavior that remain
constant across a range of hypothetical environments. Although such
structural parameters are needed to analyze an interesting class of policy interventions, most often included among them have been parameters of equations describing the rules of choice for private agents.
NEW ECONOMETRIC
METHODS
A major research effort is currently under way by economists to develop theoretical and econometric methods capable of isolating parameters that are structural in the above sense, that is, parameters that are
invariant under govemment interventions in the form of changes in the
rules of the game. This is a very ambitious undertaking, one that is in
many ways more difficult and ambitious than was the impressive effort
of the Cowles Commission in the late 1940s that created the econometric methods that made Keynesian econometric models possible:
For what is required is a theoretical and statistical framework that permits the economist to estimate how private agents decision rules or
strategies depend on the decision rules or strategies used by the govemment. Any successful version of this research effort will embody
12
RATIONAL
EXPECTATIONS
AND
HISTORICAL
MACROECONOMICS
the principie that the parameters of private agents decision rules are
not among the free parameters of the model, but are themselves functions of (among other things) parameters describing the rules used by
the govemment. Achieving success in this endeavor requires that
many new methods and results be achieved in technical aspects of
econometrics and dynamic economic theory.
Lucas and Sargent have formalized the ideas behind this research
effort in the following way. They let h denote a collection of decision
rules of private agents. Each element of h is itself a function that maps
some private agents information about his state at a particular point
in time into his decision at that point in time. Consumption, investment, and demand functions for money are all examples of elements
of h. Lucas and Sargent letfdenote a collection of elements that forms
the environment
facing private agents. Some elements of f represent rules of the game or decision rules selected by the govemment,
which map the govemments information at some date into its decisions at that date. For example, included among f might be decision
rules for fiscal and monetary policy variables. The fundamental principlc that WCare conccrncd with can bc summarizcd as stating that the
elements of h are partly functions of f. Lucas and Sargent represent
this mapping formally by
Ir - 7(f)
(1.14)
AND
CROSS-COUNTRY
ANALYSIS
13
AND CROSSCOUNTRY
ANALYSIS
History provides a number of examples of economies that have apparently operated for more or less extended periods of time under aher-
14
RATIONAL
EXPECTATIONS
AND
MACROECONOMICS
IMPLICATIONS
FOR
POLICYMAKERS
15
FOR POLICYMAKERS
These ideas have implications not only for theoretical and econometric
practices but also for the ways in which policymakers and their advisers think about the choices confronting them. In particular, the rational
expectations approach directs attention away from particular isolated
actions and toward choices among feasible rules of the game, or repeated strategies for choosing policy variables. While Keynesian and
monetarist macroeconomic models have been used to try to analyze
what the effects of isolated actions would be, it is now clear that the
answers they have given have necessarily been bad, if only because
such questions are ill-posed.
In terms of our investment example, by selecting different values for the first row of A, we can analyze the effects on current and
subsequent investment of switching from one well-understood policy
for setting the tax rate to another-that is, we can analyze the effccts ol diffcrcn~ srrrrrc~~irs tor sctting the tnx rntc. Howcver, WC
cannot analyze the effects on current and subsequent investment of
altemative acfions consisting of different possible settings for the tax
rate T, rlt A prrtlcslar pnlnt in timo I = i. Por in order to makc prc- li
dictions. we must specify agents views about the law of modon A,
and this is not done when we simply consider actions consisting of
altemative settings for T, at one isolated point in time. This idea is
so widely accepted as to be uncontroversial among decision theorists
(and football fans); but even today practicing macroeconomists often
ignore it.
To take a concrete example, in the United States there was recently interest in analyzing what would happen to the rate of domestic
extraction of oil and gas if the tax on protits of oil producers increased
a lot on a particular date. Would supply go up or down if the tax were
raised to X percent on July l? The only scientitically respectable answer to this question is 1 don? know. Such a rise in the oil-profits
tax rate could be interpreted as reflecting ene of a variety of different
16
RATIONAL
EXPECTATIONS
AND
MACROECONOMICS
NOTES
in
isolation
from
the
policy
rule
or
strategy
of
which
they
are an element.
inflationary?
This
question
is also
ill-posed
because
it fails
to
~pccify
17
NOTES
1. Charles
Whiteman
and lan Bain are responsible
for impressing
upon me
the many parallels
between
football
and macroeconomics.
This example
is admitledly
one that will strike true football
fans as excessively
crude.
Morc
delicate
examples
of actual changes
in rules abound,
such as the
effects on the game of moving
the goalposts
in the NFL back ten yards
in 1974, of the rule change in 1974 that a missed field goal outside
the
20.yard
line rcsulted
in the hall bcing tumed over to the other team at the
original
line of scrimmage, or the rule change in 1974 forbidding defensive backs from hitting receivers after they had moved five yards downfield from the line of scrimmage.
2. This is the message of Lucas 131.
3. Lucas and Sargent
[4] providc
a brief explanation
of econometric
models
and their uses in macrceconomics.
4. This evidente
is cited by Litterman
[2] and his referentes.
5. Sims [7] and Lucas [3] describe
why econometric
mcdels
can perform
wcll
in cnlr~~ptdstin~
thc ~IIUTC fmm thc past, nusuming
no changes
in
rules of the gamc, wllile perlorming
poorly
In predicting
thc consequcnces
of changes in the rules.
6. For an example
of such rescarch and extensive
lisis of furthcr
referentes,
18
RATIONAL
EXPECTATIONS
AND
MACROECONOMICS
Il.
As claimed
in note 8, the parameters
h. a, 8 can be shown 10 be fuflctions of the parameters
f,,h,A.
d of the present value function
being
maximized
in the equation.
12. If suffcient
data are availablc.
these same econometric
methods
can be
readily
moditied
to pooling
observations
on h,,f, from several
regimes
i=
I;.,,
n in arder 10 estimate
7. The reader of Hansen and Sargent
[I] can immediately
see how samples
of data drawn
from different
h,,f,
can be pooled
using either
the maximum
likelihood
or method
of moments estimator.
REFERENCES
1. Hansen,
Lars P., and Thomas
J. Sargent.
1980.
ing dynamic
linear rational
expectations
models.
Formulating
Journol
of
and estimat-
cha p ter
Reaganomics
Credibility
and
Ecomvnic Dy
of forecasting
using vector
autoReserve
Bank of Minneapolis.
policy evaluation:
A critique.
In
ed. by K. Brunner
and A. H.
Series on Public Policy
1: 19-46.
Allcl
Krynrhlan
,,,,,
Q~lorfurly
Rtvraw 3
croeconomica
Federal
He<rrve
Harrk 01 Minneapolis
(Spring):l-16.
eds 1981. Rtrrionnl l$ectr~tionc
and Economerric
Pracliw. Mins. _-.,
neapolis:
Univcrsity
of Minrrcso~u
Prcss.
6. Sargcnf.
Thomas
J 1979. M<rt~rorconrvnic
Thmry. New York: Academic
Press.
7. Sims, Christopher
A. 1980. Macroeconomics
and reality.
Economerrica
48
(January):l-48.
HOWARD:Dandy,
Vikrs
ln(o
Ihc
scnnd
ludl.
throughout
slaya
Otherwlse,
with
hs
MCINDAYNIGHTFOOTBALL
19