Rational Expectations and Animal Spirits

Along with the rest of modern macroeconomics, the rational expectations (RE) assumption has gotten quite a bit of flack lately. I don’t think all of it is deserved.  It is not the rational expectations (RE) assumption that is at fault: It is the rational expectations assumption in conjunction with the assumption of a unique equilibrium. 

In standard dynamic stochastic general equilibrium (DSGE) models there is a single rational expectations equilibrium. In the models I work with there are many rational expectations equilibria. Not just one, or two or three: but an infinite dimensional continuum of them. That is not a problem. It is an opportunity that I exploit to model the idea that beliefs matter. In my work, I close my models by adding an equation that I call a 'belief function'. The belief function is an effective way of operationalizing the Old Keynesian assumption of ‘animal spirits’. It is a forecasting rule that explains how people use current information to predict the future. That rule replaces the classical  assumption that the quantity of labor demanded is always equal to the quantity of labor supplied.

You might think that adding a belief function to operationalize animal spirits allows me to dispense with the rational expectations assumption since the belief function could be arbitrary. Not so. Even though we do not live in a stationary environment, our beliefs should be consistent with the outcomes that we would observe in a stationary world.  In such a world, beliefs should obey Abraham Lincoln’s dictum that “you can fool all of the people some of the time or some of the people all of the time but you can’t fool all of the people all of the time.”  In my view, that is the rational expectations assumption.

Suppose you are building a rational expectations model with a unique equilibrium. In that model, you would  not need to independently model a ‘belief function’.  The people in your model would need to forecast the future somehow, and presumably they would use some kind of forecasting rule.  But you would not need to know the parameters of that rule.  Whatever rule they use; it would have to be correct ‘on average’.

Stick with the unique RE assumption and suppose that the fundamentals change.  Perhaps there is a new Fed Chairperson, or perhaps someone invents a new technology. In a standard DSGE model, the rule that people use to forecast the future would need to change. The belief function in this world is endogenous.

Now move to my parallel universe where there is a continuum of RE equilibria.  In my universe the rule that people use to forecast the future is critical.  It is the belief function that selects the equilibrium. If people believe that there will be high unemployment; that belief will be self-fulfilling.

In my world, ask what happens if the fundamentals change.  Perhaps there is a new Fed Chairperson or perhaps there is a new technology.  In this world, the belief function selects a new equilibrium. Beliefs are fundamental!

Are beliefs really fundamental?  I think so. This is a not a radical idea; it is a new way of understanding an old one. Central bankers have known for a long time that expectations of future inflation are highly persistent. That persistence is often cited as one of the strikes against either the rational expectations assumption or the equilibrium assumption. I believe that both of those accusations are misplaced. Persistent expectations is a strike against rational expectations PLUS the uniqueness assumption. It is the uniqueness assumption that needs to go; not the rational expectations assumption which simply reflects a fact that we have known for a long time: Expectations are incredibly persistent. Welcome to my alternate reality!