THE RATIONAL EXPECTATIONS REVOLUTION:

AN ASSESSMENT

Kevin P. Hoover

immutuge pie reyoj uuonary iiletapflor, ieeugni’/.iimg, Ftoweyer, mat tnerational expectations hypothesis itself is not what will commandour attention; instead we will examine the implications of thosedevelopments in macroecononrucs forwhich the rational expectationshypothesis was one of the sparks. In the following impressionisticsketch of the history of those developments, I will pay special allen-

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umacruecormomnics is ~picai UI mnese ueveiopmenis. - Iniru, econo-mists began to pay more careful attention to the processes throughwhich expectations were formed. A first pass, found for example inMilton Friedman’s (1957) theory of the consumption function orPhillip Cagan’s (1956) work on money demand in hyperinfiations,held that the expected value of a variable was formed on the basis,-t:j.. L:.,,..... ..~,1..,n.. l,,s2 ~ ,_.,.s,-.L1~

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ing for the dynamics of inflation. Paul Samuelson and Robert Solow(1960) imported time inverse relationship between inflation andunemployment diseovei’ed by A. W. Phillips (1958) to fill the gap intheKeynesian model. The Phillips curve appeared to bean empiricalfliet; its slim theoretical foundations wei-e found in labor market

ii

Muth’s rational expectations hypothesis br the Phillips curve andthe analysis of labor markets. Lucas’s ([1972a] 1981) article, “Econo-metric Testing of the Natural Hate Ilypothesis,” will serve as theparadigm.8 The article accomplished three things critical to thedevelopment of new classical macroeconomics.

First, it undermined the standard interpretation of the empirical

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structural interpretation of estimated econometric models. Keynes-ians had regarded the Phillips curve as a structural relationship. ButLucas showed that, under the rational expectations hypothesis, thecoefficients on lagged inflationdepended on the policy rule in place.Thus, when the rule changes, the coefficients themselves must

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rumes were anamyzen as tue outcome on an optimization proulem;second, the range of policymakers’ concerns was extended beyondthe real economy to include an aversion to inflation;10 and third,rules were analyzed in richer dynamic settings. To take the last pointfirst, Finn Kydland and Edward Prescott (1977) pointed out that,when choosing an optimal rule in a dynamic setting, policymakors

nulls, even am mime aggregaTe level. - ~eeommu,pomicy experiments areincori-ectly conceptualized in them—issues smmch as dynamic consis—teucy were not laced. Finally, they simply are not accmmrate represen-tatiomis of economimic structures that would remain invariant to changesin the policy regime; therefore, they could not be used to forecastchanges that are conditional on a new regime.

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Obscenely or not, niodels of the Sargent and lIansen type arealmost always at variance with the data. Kydlandand Prescott (1990)and Lucas (1987) regard this as the inevitable result of the failure oftime microecouomic theory to map properly onto the macroeconomicdata. The world is too complex for a model to possess both soundi-h..,-.,.,,.i-;,,,.l 4-,...,,I,-.m4,-.,~..,... ,-1 ~ c1,.i-.r1 ~ ,1nc~.~ihn,Inio

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were monetary models: Unanticipated changes in the money stockinitiated the cycle, while the dynamics of capital-stock adjustmentpropagated it over time. In the late 1970s, empirical investigationof unanticipated money as the driving variable in business cyclesheld the center stage in macroeconomic research.tm7 Although thereL,... L~ ~l i--i--I-, ~ -“---I ~ ~ —--2,-I

Iieyona mat, however, tile very nature ol new classical moueisreinforces the divergence between practical and academic macroeco-nomics. Those in government and business usually want to knowwhat next year’s GNP or interest rates will be or, at best, what thepath will be over some short horizon. To the new classicals suchquestions ai’e wrongly ?05ed~,and theh models are not adapted to

uinauumi iJro~memmmsmay ieau to mmmuiupme ammu sum—sustaining, out smio—optimal, equilibria.22 And fourth, the mommetany system, as opposedto narrow definitions of money, may not be neutral. The problemsof financing real activities on credit markets subject to their ownupheavals may contribute to the suboptimal use of resources.’3

- - ‘I’hc fourth point carries a final irony: For years monetarists insisted

don: George Allen & Unwin, 1981.Barro, Robert J. “Unanticipated Money, Ontput, and the Price Level in the

United States.” 1978. Reprinted in Rational Expectations and Economet-ric Practice. Edited by Robert E. Lucas, Jr., and Thomas J. Sargent, Lon-don: George Allen & Unwin, 1981.

Bairn, Robert J., and Gordon, David B. “A Positive Theory of MonetaryPolicy in aNatnmal Rate Model.” burma

1of Political Economy 91 (Augnst

nal Expectations and Econometric Practice. Edited hy Robert E. Lncas,Jm’., and Thomas J. Sargent. London: George Allen & Unwin, 1981.

Floover, Kevin D. The New Classical Macroeconomics: A Sceptical Inquiry.Oxford: Blackwell, 1988.

Hoover, Kevin I). “Scientific Research Programme or Tribe? A JointAppraisal of Lakatos and the NewClassical Macroeconomics.” In Apprais-ing Economic Theories: Studies in the Application of the Methodology

100 (May 1985): 529—37.Mishkin, Frederic S. A Rational ExpectationsApproach to Macroeconomics:

Testing Policy Effectiveness and Efficient Market Models. Chicago: Uni-versity of Chicago Press, 1983.

Modigliani, Franco, and Brnmberg, R. “Utility Analysis and the Consump-tion Function: An Interpretation ofCross-Section Data.” In Post-KeynesianEconomics. Edited by K. Kurihara. New Brunswick, N.J.: Rutgers Univer-

(March 1980): 1—48. -

Sims, ChristophcrA. “Policy Analysis with Econometric Modeb.” BrookingsPaper.s omm Economic Activity 13, no. 1 (1982): 107—52.

Simns, Christopher A. “Are Forecasting Models Usable for Policy Analysis?”I”ederalReserve Bank of Minneapolis Quarterly Review 10 (Winter 1986):2—15.

Tobin, lames. “The Interest Elasticity of the Transactions Demand for

RATIONAL EXPECTATIONS AND THE NEWCLASSICAL MACROECONOMICS

David I. Meiselman

lion, market pricing, and market-clearingprocesses. Those processesinclude the discounting of actual or anticipated future events suchis prices, incomes, interest rates, and public policies. Thus, expecta-tions of future events are central and necessary to the discountingprocess.

In his intellectual history of the demise of the Keynesian system,

to oiler pnulic oltmeiais or private sector businesspeople ann mnvestorswho continue to ask the same serious questions about making andusing short-run economic forecasts and about the short-run effects

of various public policies, including so-called stabilization policies.Also, the new models generally assume a closed rather than an openeconomy. They neglect influences to and from abroad—a serious

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systematically alter those real variables; it could only add monetarydisturbances, which often had the perverse effect of making worse

the supposed problem that more (or less) money was intended toalleviate. Forexample, as weall know now from much painful experi-ence, trying to lower interest rates by rapid money growth not only

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in questioning older, ilawed tneories ann in raising vaiin questionsabout the many and varied tinkerings with monetary and fiscal poli-cies, it is not clear that the rational expectations hypothesis and newclassical macroeconomics have contributed a usable alternative tothe quantity theory, particularly in a world with national domesticeconomies open to international trade and international financial

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that (h) governments and bureaucrats have the information andknowledge to do so. Such beliefs ignore both the multiple, conflict-ing, and often inconsistent pressures on governments and the multi-pIe, conflicting, and inconsistent policies that governments typically

pursue. ‘I’hese policies reflect, in part, the range of diverse pressures,I .-u-~,-.~ .,c,u-.,-,:.. ~ .-.i:,.,-.-.s.- ~-. -.11

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ties cannot and will not commit institutional suicide by adopting afixed strategy, including any stabilization or monetary policy rules.Indeed, the Fed will not adopt such rules and will fight, as it hasfought, any attempt to have rules or fixed strategies imposed on itthat would make monetary policy predictable. Instead, the Fed’s

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and observed lags tend to become more variable. It is as if whitenoise or a random component were added to each variable. Allbecome more difficult or impossible to isolate and toquantify. Under-lying systematic relationships become blurred or buried.

The irony is that the Fed cannot hope to be credible if it fails to.-.I-.: .-. Ld:.~,.i ..-,.,.,,.-.I,, ‘I ii,. 1?_.1

• A goal oI zero inflation, or at least an avoidance ot the deliberateuse of inflation to solve or cover up other problems such asunemployment, a weak housing market, and the like, In otherwords, we would shun the Phillips curve snare or the delusionthat monetary change has dependable and controllable realeffects.

My comments are not meant to be critical of Floover’s scholarlypaper, which is an excellent summary and critique of major andfundamental changes in macroeconomics and monetary theory inthe past 20 years. His paper and, even more, his book, The New

Classical Macroeconomics, are excellent guides to the literature andto the issues. Both works are well written, finely nuanced, and