# Rational Expectations and Econometric Practice: Volume 1

Robert E. Lucas
Thomas J. Sargent
Edition: NED - New edition
Pages: 408
https://www.jstor.org/stable/10.5749/j.ctttssh5

1. Front Matter
(pp. i-vi)
(pp. vii-x)
3. Introduction
(pp. xi-xl)

After A remarkably quiet first decade John Muth’s idea of “rational expectations” has taken hold, or taken off, in an equally remarkable way. The term now enjoys popularity as a slogan or incantation with a variety of uses. It may also suffer some notoriety due to presumed links with conservative political views or with excessive concern over the consequences of money supply changes.The term “rational expectations” carries, it seems, achargeof some magnitude.

In our view, this charge is not incidental or uninteresting: Muth’s hypothesisisa contribution of the most fundamental kind, an idea that compels rethinking on...

4. 1. Implications of Rational Expectations Econometric Practice
• 1 “Rational Expectations and the Theory of Price Movements.”
(pp. 3-22)
John F. Muth

In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory. In particular, the hypothesis asserts that the economy generally does not waste information, and that expectations depend specifically on the structure of the entire system. Methods of analysis, which are appropriate under special conditions, are described in the context of an isolated market with a fixed production lag. The interpretative value of the hypothesis is illustrated by introducing commodity speculation into the system.

That expectations of economic variables may be subject to...

• 2 “Optimal Properties of Exponentially Weighted Forecasts.”
(pp. 23-32)
John F. Muth

Forecasts derived by weighting past observations exponentially (i.e., geo-metrically) have been used with some success in operations research andeconomics. Magee (1958), Winters (in press),¹ and Brown (1959) have usedthis approach in short-term forecasting of sales, primarily in inventorycontrol. Distributed lags, while not always arising from explicit forecasts,have appeared in studies of capacity adjustment by Koyck (1954), de-mand for cash balances during hyperinflations by Cagan (1956), the con-sumption function by Friedman (1957), and agricultural supply functionsby Nerlove (1958). Its main a priori justification as a forecasting relationhas been that it leads to correction of persistent errors, without respondingvery much to random...

• 3 “A Note on the ‘Accelerationist’ Controversy.”
(pp. 33-38)
Thomas J. Sargent

Recent empirical tests of the Phelps-Friedman “accelerationist” view of the Phillips curve are marred by the fact that their validity is predicated on the adequacy of a very suspect maintained hypothesis.¹ Those tests all involve obtaining estimates of the notorious parameter “α” in the following equation designed to explain the movement of wages over time:

$\frac{{\Delta \omega {}_t}}{{\omega {}_{t - 1}}} = \alpha \pi {}_t + f(U{}_t,...) + \in {}_t.$

Here${\pi _t}$is the public’s anticipated rate of commodity price inflation,${\omega _t}$is the wage rate at timet,Utis the unemployment rate, and$\partial f(/\partial U, ...)is the short run philips curve with that${partial f/\partial U < 0}$and with the sequence... • 4 “Distributed Lags and Optimal Investment Policy.” (pp. 39-54) Robert E. Lucas Jr. The literature on optimal investment policy for a single firm has grown rapidly in recent years.¹ It is now widely agreed that a satisfactory microeconomic theory of capital should account not only for the determination of the firm’s “desired” capital stock, but also for the adjustment process by which this stock is attained (or approached). There are a number of plausible reasons why one might expect a present value maximizing firm to stagger its adjustment to a new equilibrium level of capital stock (assuming an equilibrium level exists) among which should be listed costs of accumulation which vary with its... • 5 “Optimal Investment with Rational Expectations.” (pp. 55-66) Robert E. Lucas Jr. Most recent work in investment theory has been concerned with the present value maximization problem of an individual firm. That is, it is directed at the question: how should a firm with given production possibilities and initial assets respond to an anticipated pattern of future prices and interest rates? In many applications, it is of at least equal interest to restate the question at theindustrylevel: how will a competitive industry, composed of optimizing firms, respond to shifts in its demand and factor supply functions? In particular, the latter statement of the problem is more relevant to econometric investment... • 6 “Investment under Uncertainty.” (pp. 67-90) Robert E. Lucas Jr. and Edward C. Prescott Explanatory variables in empirical studies of the demand for investment goods fall into three broad classes: variables measuring anticipated, future demand—sales, profits, stock price indexes; variables measuring past decisions, the effects of which persist into the present—lagged capital stock and investment rates; and variables measuring current market opportunities—interest rates, factor prices, and, again, profits.¹ Existing investment theory has concerned itself largely with the latter two classes of variables, first by rationalizing the role of prices in determining a long-run “desired” capital stock using a static, profit maximizing hypothesis, later by discovering the optimizing basis for a staggered... • 7 “Formulating and Estimating Dynamic Linear Rational Expectations Models.” (pp. 91-126) Lars Peter Hansen and Thomas J. Sargent This paper describes research which aims to provide tractable procedures for combining econometric methods with dynamic economic theory for the purpose of modeling and interpreting economic time series. That we are short of such methods was a message of Lucas’s (1976) criticism of procedures for econometric policy evaluation. Lucas pointed out that agents’ decision rules, e.g., dynamic demand and supply schedules, are predicted by economic theory to vary systematically with changes in the stochastic processes facing agents. This is true according to virtually any dynamic theory that attributes some degree of rationality to economic agents, e.g., various versions of “rational... • 8 “Linear Rational Expectations Models for Dynamically Interrelated Variables.” (pp. 127-156) Lars Peter Hansen and Thomas J. Sargent This paper aims to develop procedures for the rapid numerical computation and convenient mathematical representation of a class of multiple variable, linear stochastic rational expectations models. A variety of examples from this class of models can be imagined. These include versions of interrelated factor demand models like Mortensen’s (1973) formed by blending the model of Nadiri and Rosen (1973) with the adjustment cost models of Lucas (1967a, b), Gould (1968), and Treadway (1969, 1971); models of exhaustible resource extraction along the lines of Epple and Hansen (1979); and dynamic linear models of interrelated industries, such as the corn and hog... 5. 2. Macroeconomic Policy • 9 “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment.” (pp. 159-198) Thomas J. Sargent The interaction of expected inflation and nominal rates of interest is a topic that has received its share of attention since Milton Friedman gave Irving Fisher’s theory a prominent role in his presidential address to the American Economic Association in 1967.¹ The relationship between interest and expected inflation depends intricately on the interactions of the real and financial sectors of the economy, so that the subject of this paper lies in the domain of macroeconomic analysis. Partial equilibrium analysis won’t do. Therefore, even though my main subject is the relationship between interest rates and expected inflation, there is no way... • 10 “Rational Expectations and the Theory of Economic Policy.” (pp. 199-214) Thomas J. Sargent and Neil Wallace There is no longer any serious debate about whether monetary policy should be conducted according to rules or discretion. Quite appropriately, it is widely agreed that monetary policy should obey a rule, that is, a schedule expressing the setting of the monetary authority’s instrument (e.g., the money supply) as a function of all the information it has received up through the current moment. Such a rule has the happy characteristic that in any given set of circumstances, the optimal setting for policy is unique. If by remote chance, the same circumstances should prevail at two different dates, the appropriate settings... • 11 “‘Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule.” (pp. 215-228) Thomas J. Sargent and Neil Wallace This paper analyzes the effects of alternative ways of conducting monetary policy within the confines of an ad hoc macroeconomic model. By ad hoc we mean that the model is not derived from a consistent set of assumptions about individuals’ and firms’ objective functions and the information available to them. Despite this deplorable feature of the model, it closely resembles the macroeconomic models currently in use, which is our excuse for studying it. Following Poole (1970), we compare two alternative strategies available to the monetary authority. One is to peg the interest rate period by period, letting the supply of... • 12 “Rational Expectations and the Role of Monetary Policy.” (pp. 229-260) Robert J. Barro The purpose of this paper is to analyze the role of monetary policy in a model with three major characteristics: (1) prices and quantities are competitively determined by market-clearing relationships—that is, by the solution of a competitive equilibrium system; (2) information is imperfect; and (3) expectations of future variables are formed rationally, in the sense of being optimal predictions based on the available information. The focus of the analysis is on the effects of monetary expansion on prices and outputs. Part 1 of the paper generates a Phillips-curve-type relation in a framework that builds on the work of Friedman... • 13 “Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule.” (pp. 261-276) Stanley Fischer This paper is concerned with the role of monetary policy in affecting real output and argues that activist monetary policy can affect the short-run behavior of real output, rational expectations notwithstanding. Recent contributions¹ have suggested that the behavior of real output is invariant to the money supply rule chosen by the monetary authority if expectations are formed rationally. The argument to the contrary advanced below turns on the existence of long-term contracts in the economy and makes the empirically reasonable assumption that economic agents contract in nominal terms for periods longer than the time it takes the monetary authority to... • 14 “Price-Level Stickiness and the Feasibility of Monetary Stabilization Policy with Rational Expectations.” (pp. 277-284) Bennett T. McCallum Several recent papers have demonstrated a striking theoretical result concerning the feasibility of countercyclical monetary policy.¹ This result, which I shall refer to as the Lucas-Sargent Proposition, may be stated as follows: if aggregate-supply fluctuations are initiated by informational errors² and if economic agents’ expectations are formed rationally, then countercyclical monetary policy will be entirely ineffective.³ This proposition provides powerful intellectual support for Milton Friedman’s proposal that monetary authorities abandon attempts to lean “against” prevailing cyclical tendencies, acting instead so as to generate steady growth of the nominal money stock at some constant rate.⁴ In reaction, Edmund Phelps and John... • 15 “The Current State of the Policy-Ineffectiveness Debate.” (pp. 285-292) Bennett T. McCallum The debate in question is, of course, over the applicability to the U.S. economy of the famous and controversial “neutrality” proposition—due primarily to Robert Lucas, Thomas Sargent, and Neil Wallace—according to which the choice among monetary policy feedback rules is irrelevant for the stochastic behavior of the unemployment rate in a neoclassical economy with rational expectations. Since the basic logic of this proposition has become well-known, I will not devote space to a formal statement or proof. It will be necessary, however, to inject some interpretive comments. This need arises because formal proofs of the proposition refer to... 6. 3. Econometric Methods:: General • 16 “After Keynesian Macroeconomics.” (pp. 295-320) Robert E. Lucas Jr. and Thomas J. Sargent For the applied economist, the confident and apparently successful application of Keynesian principles to economic policy which occurred in the United States in the 1960s was an event of incomparable significance and satisfaction. These principles led to a set of simple, quantitative relationships between fiscal policy and economic activity generally, the basic logic of which could be (and was) explained to the general public and which could be applied to yield improvements in economic performance benefitting everyone. It seemed an economics as free of ideological difficulties as, say, applied chemistry or physics, promising a straightforward expansion in economic possibilities. One... • 17 Estimation of Economic Relationships Containing Latent Expectations Variables (pp. 321-328) John F. Muth Econometric studies are plagued by the fact that available statistics bear no close relationship to the variables appearing in the conceptual model. Data must usually be adjusted for spurious scale factors (inflation and population growth in partial equilibrium models), for extraneous variables or inappropriate weights in aggregated series, and so on. A further problem arises from the fact that expectations of events (income, prices, sales) are fully as important in economic models as the realizations themselves—and good expectations data are hard to come by.¹ Using lagged variables as a substitute for expectations has become almost automatic in econometric studies... • 18 “Econometric Implications of the Rational Expectations Hypothesis.” (pp. 329-354) Kenneth F. Wallis 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 are relatively rare, hence implicit forecasting schemes are used. Most commonly expectations are 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”... • 19 “Estimation of Rational Expectations Models.” (pp. 355-367) Gregory C. Chow This paper considers the estimation of linear rational expectations models when the objective function of the decision maker is quadratic. It presents methods for maximum likelihood estimation in the general case and in a special case when the decision maker’s action is assumed to have no effect on the environment (as under perfect competition). It proposes a family of consistent estimators for the general case. It also comments on the assumptions of rational expectations models, and extends the above methods to estimating nonlinear models. In an optimal control problem where the model is linear${y_t} = A{y_{t - 1}} + C{x_t} + b + {u_t}\$

and the objective function to...

7. Back Matter
(pp. 368-368)