Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 11 March 2012

Rational Expectations and Phillips Curves

              Two small points following up on my previous post on microfoundations.

1) Adopting rational expectations as the default expectations model has never meant (for me at least) ignoring the possibility of non-random expectations errors. As Lars Syll points out, the informational demands of rational expectations are very strong. However, we need to model expectations by some means. What rational expectations allows you to do is think about expectations errors in a structural way. We can think about deviations from rational expectations, just as we can think about shocks to behavioural relationships. The problem with what went before rational expectations (e.g. adaptive expectations) is that expectations errors were built in, and in most situations these built in errors were not terribly plausible.
Hopefully models of learning will eventually allow expectations errors to be analysed in a more plausible, systematic and routine way. 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. As my next door neighbour in the department at Oxford works in this area (see for example Ellison, Martin & Pearlman, Joseph, 2011. "Saddlepath learning," Journal of Economic Theory, Elsevier, vol. 146(4), pages 1500-1519), I couldn’t possibly disagree. However I think it is highly unlikely that learning will negate the advances in understanding monetary policy that I referenced in my previous post.
For some variables in some situations, a baseline where expectations were formed in a naive way might be more appropriate. Some aspects of risk maybe? However inflation in a business cycle with an independent central bank is not one of these. David Glasner talks here about the “the tyrannical methodology of rational expectations”. I just do not see it that way. Rational expectations do not prevent us understanding sustained periods of deficient demand when an inflation targeting central bank hits a lower bound. Indeed they help, because with rational expectations inflation targeting prevents inflation expectations delivering the real interest rate we need, as I have argued here.  

2) I talked about both rational expectations and the New Keynesian Phillips curve (NKPC) in providing the theoretical impetus to inflation targeting by independent central banks. A comment asked why I put the two together. The latter goes with the former, because rational expectations with the more traditional Phillips curve imply deviations from the natural rate are random, which is totally destructive of Keynesian theory. (If inflation at time t depends on the output gap and expected inflation at time t - rather than t+1 as in the NKPC - and the difference between actual and expected inflation is a random error because expectations are rational, then the output gap is also a random error.)
The traditional Phillips curve has always seemed to me to be an advertisement for the dangers of not doing microfoundations. It seems plausible enough, which is why it was used routinely before the rational expectations revolution. But it contains the serious flaw noted above, which almost destroyed Keynesian economics. I know this is not realistic, but imagine that Calvo (1983) ‘Staggered prices in a utility maximising framework’ Journal of Monetary Economics Vol 12 pp 383-398 had been published a decade or more earlier, as a direct response to Friedman’s 1968 presidential address. Who knows what would have happened next, but it is difficult to imagine the history of macroeconomic thought being worse as a result.  


  1. Economists overvalue rational expectations die to the absence of big picture. Let's take an example from physics. Particles in a box also have "rational expectations" about their future energy and trajectory. In real world, the processes with particles are irreversable and stochastic. It means that the new trajectory and energy is a pure innovation to any of the particles together with the time of this innovation. However, the overall behaviour of the (closed) system can be described by a few simple relationships between macrovariables (the gas laws). How are the gas laws related to economics? There is a simple answer. The relative distribution of personal incomes (as reported by the Cesnsu Bureau) has not been changing since 1947 (start of measurements). Hence, with all these rational or/and irrational expectations and free will, the final distribution (similar to those in physics, including the energy distribution for particles in a box) of incomes (results of all efforts) remains fixed:
    This is a gas law for incomes and thus the economy as a whole. As a direct consequence, there is a simple relationship defining price inflation in developed countries (an Euro Area Business Cycle Network (EABCN) paper

  2. Thanks for commenting on my critique, Simon.
    But I am still not convinced that it suffices to say - as you do - that "we need to model expectations by some means," and that rational expectations should do, just because it allows the macroeconomist to "think about expectations errors in a structural way." A full argumentation for WHY I consider this inadequate is posted on my blog today:

  3. Joe Pearlman is my primary Ph.D. supervisor. Small (academic) world.

  4. Simon, My negative view of rational expectations does not mean that I don't think it has an important place in macrotheory, just that it shouldn't be allowed to exclude all other expectational assumptions because anything else violates some axiom of rationality. That's what I meant by a "tyrannical methodology." The assumption should be appropriate to the problem one is trying to analyze, not dictated by some methodological imperative. The deeper problem with rational expectations in my view is that expectations can be self-fulfilling because the equilibrium is itself conditional on expectations in which case rational expectations doesn't get you very far.

  5. I too have semi defended the rational expectations assumption recently. However, the basic advantage I see is that the assumption of rational expectations makes it more difficult (not impossible) for people to tell stories about how their preferred policies are good, because (it is assumed rather than argued) they will influence expectations in a desirable way.

    Briefly, I think the point is to exorcise the confidence fairy. Less briefly, my reasoning was that, if one is not required to assume rational expectations, one can argue that cutting spending will cause increased growth by increasing business confidence. A model in which businessmen with rational expectations increase investment and production because of a spending cut is not easy to write. My guess is that it would be a model with sunspot equilibria, so anything can change investment. If so the case for expansionary austerity would be identical to the case that what we need is to burn incense to the flying spaghetti monster (which claim is consistent with the rational expectations assumption on models where sunspots can matter).

    The key question, I think, is not rational vs irrational. It isn't even rational vs adaptive. It is whether we should treat expectations as a policy variable imagining that policy makers can control them as they control, say, the federal funds rate.

    Then I thought "same for the people who think that expected inflation is just like the federal funds rate" and here we are. I might add, I also thought "this time I won't be very rude in comment" really honestly. But, as I see it, you leave me no choice.

    Look why not just talk about a monetary authority which targets real yearly GDP. To a million pounds per capital You are simply assuming that a central bank can get the inflation expectations it wants. That rational people will believe its dynamically inconsistent promises.

    Oddly the last time I remember defending rational expectations was when I tried to explain (to Matthew Yglesias) why Paul Krugman was skeptical about the effectiveness of monetary policy right now.

    I note again that you have not identified one advance new Keynesians have made beyond Keynes. The alleged examples include speculation about UK consumption some of which, you note, is not incorporated into new Keynesian models yet and none of which has yielded an improved prediction and, of course, the old Phillips curve. The only connection between the old Phillips curve and Keynes is that he warned against believing in it as clearly as anyone could writing before Phillips.

    You contest Krugman's claim that those who seek microfoundations have had no successes since the critique of the old Phillips curve yet you go back to that again and again. I see no trace of a justification for your disagreement with Krugman in this post or in any other post of yours which I have read.

  6. More rudeness

    You write (suspected typo elided) "inflation targeting ... delivering the real interest rate we need." I note that the ECB has consistently targetted inflation (at least you are willing to give inflation targetting credit for events in 2005 and 2006. You must conclude that the Eurozone has the real interest rate we need.

    But the Eurozone suffered a severe recession, currently has extremely high unemployment and appears to be headed for a second dip.

    I think you meant to qualify the claim with "with the right inflation target, assuming (for some reason) that the target is credible ..."

  7. Waldmann's got it. So does David Glasner.

    I sometimes think the fundamental divide in economics isn't Keynesian vs. classical, or saltwater vs. freshwater, but between those who see economics as -- definitionally -- developing a family of models of optimization under constraints, which hopefully will turn out to be useful for practical questions but which can only be evaluated by their own internal criteria; vs. those who see economics as the study of the economy, using whatever mix of methodologies seems best suited to the job.

    1. In which case I am definitely in the second camp. But you have to ask why most of the profession is in the first, and what you have to do to make macro more eclectic.

  8. While strongly disagreeing about microfoundations and ratex, I have greatly enjoyed this back and forth between New Keynesians and their critics.So, first of all, thank you.

    Simon Wren-Lewis:
    "I know this is not realistic, but imagine that Calvo (1983) ‘Staggered prices in a utility maximising framework’ Journal of Monetary Economics Vol 12 pp 383-398 had been published a decade or more earlier, as a direct response to Friedman’s 1968 presidential address. Who knows what would have happened next, but it is difficult to imagine the history of macroeconomic thought being worse as a result."

    I think I understand what you are trying to get at, but nevertheless, am tempted to reply that it difficult to imagine the history of macroeconomic thought being worse in any case!

    And of course, the microfoundations stampede in the 1970s, technically, had little to do with Friedman and Phelps, both of whom had used adaptive expectations, and neither was a fan of Rational Expectations.

    Ned Phelps:
    "Unfortunately, the rational expectations models, appearing in the 1970s, sidestepped the problem of expectations formation under uncertainty by blithely supposing that the model’s actors (tellingly dubbed “agents”) knew the “correct” model and the correct model was the analyst’s model— whatever that model might be that day. The stampede toward “rational expectations”—widely thought to be a “revolution,” though it was only a generalization of the neoclassical idea of equilibrium—derailed the expectations-driven model building that had just left the station. In the end, this way of modeling has not illuminated how the world economy works."

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