Econometric Implications of the Rational Expectations Hypothesis

The implications for applied econometrics of the assumption that unobservable expectations formed rationally in Muth's sense examined. The statistical properties of the resulting models and their distributed lag and time series representations described. Purely extrapolative forecasts of endogenous variables can be constructed, as alternatives to rational expectations, but less efficient. Identification and estimation considered: an order condition is that no more expectations variables than exogenous variables enter the model. Estimation is based on algorithms for nonlinear-in-parameters systems; other approaches surveyed. Implications for economic policy and econometric policy evaluation described. EXPECTATIONS VARIABLES ARE WIDELY USED in applied econometrics, since the optimizing behavior of economic agents, which empirical research endeavors to capture, depends in part on their views of the future. Directly observed expectations or anticipations relatively rare, hence implicit forecasting schemes used. Most commonly expectations taken to be extrapolations, that is, weighted averages of past values of the variable under consideration. However, these are almost surely inaccurate gauges of expectations. Consumers, workers, and businessmen ... do read newspapers and they do know better than to base price expectations on simple extrapolation of price series alone (Tobin 31, p. 14). An alternative approach is offered by the rational expectations hypothesis of Muth 15, which assumes that in forming their expectations of endogenous variables, economic agents take account of the interrelationships among variables described by the appropriate economic theory. Price movements observed and experienced do not necessarily convey information on the basis of which a rational man should alter his view of the future. When a blight destroys half the midwestern corn crop and corn prices subsequently rise, the information conveyed is that blights raise prices. No trader or farmer under these circumstances would change his view of the future of corn prices, much less of their rate of change, unless he is led to reconsider his estimate of the likelihood of blights, again quoting Tobin. This paper examines the implications of the rational expectations hypothesis for applied econometrics, and argues that its full force has yet to be appreciated in empirical work. The discussion is quite general, proceeding in terms of the standard linear simultaneous equation system, and pays little attention to specific applications of the hypothesis, such as the efficient markets literature and