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Rethinking Expectations

Rethinking Expectations: The Way Forward for Macroeconomics

Roman Frydman
Edmund S. Phelps
Copyright Date: 2013
Pages: 440
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  • Book Info
    Rethinking Expectations
    Book Description:

    This book originated from a 2010 conference marking the fortieth anniversary of the publication of the landmark "Phelps volume,"Microeconomic Foundations of Employment and Inflation Theory, a book that is often credited with pioneering the currently dominant approach to macroeconomic analysis. However, in their provocative introductory essay, Roman Frydman and Edmund Phelps argue that the vast majority of macroeconomic and finance models developed over the last four decades derailed, rather than built on, the Phelps volume's "microfoundations" approach. Whereas the contributors to the 1970 volume recognized the fundamental importance of according market participants' expectations an autonomous role, contemporary models rely on the rational expectations hypothesis (REH), which rules out such a role by design.

    The financial crisis that began in 2007, preceded by a spectacular boom and bust in asset prices that REH models implied could never happen, has spurred a quest for fresh approaches to macroeconomic analysis. While the alternatives to REH presented inRethinking Expectationsdiffer from the approach taken in the original Phelps volume, they are notable for returning to its major theme: understanding aggregate outcomes requires according expectations an autonomous role. In the introductory essay, Frydman and Phelps interpret the various efforts to reconstruct the field--some of which promise to chart its direction for decades to come.

    The contributors include Philippe Aghion, Sheila Dow, George W. Evans, Roger E. A. Farmer, Roman Frydman, Michael D. Goldberg, Roger Guesnerie, Seppo Honkapohja, Katarina Juselius, Enisse Kharroubi, Blake LeBaron, Edmund S. Phelps, John B. Taylor, Michael Woodford, and Gylfi Zoega.

    eISBN: 978-1-4008-4645-0
    Subjects: Economics, Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-viii)
  3. Which Way Forward for Macroeconomics and Policy Analysis?
    (pp. 1-46)
    Roman Frydman and Edmund S. Phelps

    There was a palpable sense of excitement among the economists who met in Philadelphia in 1969 at the conference organized by Edmund Phelps. Their research over the preceding years had coalesced into a new approach to macroeconomic analysis, one that based macrorelationships on explicit microfoundations. These foundations’ distinctive feature was to accord market participants’ expectations an autonomous role in economists’ models of aggregate outcomes. The conference contributions, published in what came to be known as “the Phelps microfoundations volume” (Phelps et al. 1970), provided radically new accounts of the comovements of macroeconomic aggregates—notably, inflation and unemployment. They also cast...

  4. PART ONE Back to the Foundations

    • CHAPTER ONE Expectational Coordination Failures and Market Volatility
      (pp. 49-67)
      Roger Guesnerie

      The stability of market economies has been a recurrent subject of debate since the beginning of the nineteenth century, which is usually viewed as the starting point of economics as a scientific field. “L’offre crée sa propre demande” (“supply creates its own demand”): this formula, a remarkable digest of the argument, is supposed to capture the essence of Jean Baptiste Say’s analysis (1803). It expressed the basis for some of the early protagonists’ strong confidence in the systemic stability of markets. But others strongly disagreed: Jean Baptiste Sismondi and the “catastrophist school”—and its most famous adept, Karl Marx—awaited...

    • CHAPTER TWO Learning as a Rational Foundation for Macroeconomics and Finance
      (pp. 68-111)
      George W. Evans and Seppo Honkapohja

      Expectations play a central role in modern macroeconomics. Economic agents are assumed to be dynamic optimizers whose current economic decisions are the first stage of a dynamic plan. Thus, households must be concerned with expected future incomes, employment, inflation, and taxes, as well as the expected trajectory of the stock market and the housing market. Firms must forecast the level of future product demand, wage costs, productivity levels, and foreign exchange rates. Monetary and fiscal policymakers must forecast inflation and aggregate economic activity, and they must consider both the direct impact of their policies and the indirect effect of policy...

    • CHAPTER THREE Keynes on Knowledge, Expectations, and Rationality
      (pp. 112-129)
      Sheila Dow

      In his seminal 1968 article, and in the edited volume that followed in 1970 (Phelps et al. 1970), Phelps refocused economists’ attention on expectations formed with incomplete information. In doing so, he referred back to Keynes’sGeneral Theory,particularly to Keynes’s analysis of the labor market. The purpose here is to revisit Keynes’s work with special emphasis on his treatment of knowledge, expectations, and rationality. The focus is not only on his ideas on expectations formation but also on the degree of confidence attached to those expectations (i.e., uncertainty) and what this means for macroeconomic theory. Specifically, because uncertainty stands...

    • CHAPTER FOUR The Imperfect Knowledge Imperative in Modern Macroeconomics and Finance Theory
      (pp. 130-166)
      Roman Frydman and Michael D. Goldberg

      Modern macroeconomics constructs models of aggregate outcomes on the basis of mathematical representations of individual decisionmaking, with market participants’ forecasting behavior lying at the heart of the interaction between the two levels of analysis. Individuals’ forecasts play a key role in how they make decisions, and markets aggregate those decisions into prices. The causal processes underlying both individual decisions and aggregate outcomes, therefore, depend on market participants’ understanding of the economy and on how they use this knowledge to forecast the future.

      Over the past four decades, economists have come to a nearly universal consensus that the Rational Expectations Hypothesis...

  5. PART TWO Autonomous Expectations in Long Swings in Asset Prices

    • CHAPTER FIVE Heterogeneous Gain Learning and Long Swings in Asset Prices
      (pp. 169-206)
      Blake LeBaron

      Many asset prices exhibit large and highly persistent deviations from their fundamental values, yielding potential long-run predictability.¹ That asset prices can move from simple benchmark rational pricing levels and then stay far from these levels for some time is a major puzzle. The swings can be both short or long in duration, and their time series shows few regular patterns when one analyzes their long-range behavior. Many explanations have been proposed involving varying levels of rationality, knowledge, and learning, but no one explanation has dominated the debate. This chapter explores an underparameterized learning model with heterogeneous gain parameters and traders...

    • CHAPTER SIX Opening Models of Asset Prices and Risk to Nonroutine Change
      (pp. 207-248)
      Roman Frydman and Michael D. Goldberg

      Financial markets are, in most respects, prototypes of the markets for which much of contemporary economic analysis was designed. They are characterized by a large number of buyers and sellers; powerful monetary incentives; few, if any, barriers to entry and exit; no impediments to the adjustment of prices; and a plethora of available information that is quickly disseminated around the world. We would expect that financial markets would offer the best opportunity for contemporary economic models to provide explanations of aggregate outcomes. But it is precisely in these markets that contemporary macroeconomic and finance theory has encountered many of its...

  6. PART THREE Rethinking Unemployment-Inflation Trade-offs and the Natural Rate Theory

    • CHAPTER SEVEN Animal Spirits, Persistent Unemployment, and the Belief Function
      (pp. 251-276)
      Roger E. A. Farmer

      This chapter provides an interpretation of persistence in the unemployment rate that draws from two central ideas in Keynes’sGeneral Theory(1936). The first is that any unemployment rate can persist as an equilibrium. The second is that the unemployment rate that prevails is determined by animal spirits.

      Existing nonclassical approaches to economic policy are grounded in New Keynesian economics, an approach based on the idea that there are frictions that prevent prices from quickly adjusting to their Walrasian levels. In this chapter I present a three-equation monetary model that provides an alternative to the New Keynesian representation of the...

    • CHAPTER EIGHT Indeterminacies in Wage and Asset Price Expectations A Structuralist Model of Employment and Growth
      (pp. 277-300)
      Edmund S. Phelps

      When the contributors to the volumeMicroeconomic Foundations(Phelps et al. 1970) met at the University of Pennsylvania in January 1969, we felt we were present at the creation—the creation of a new macroeconomics. I conceived and organized both the conference and the volume—and authored much of it, too—so I take special pride in its seminal contribution to the profession.

      My work in this mold, which started in January 1966, grew out of my awareness that Keynesian economics did not have a microeconomics to accompany its macroeconomic story. I had no other quarrel with it at that...

    • CHAPTER NINE The Long Swings of Employment, Investment, and Asset Prices
      (pp. 301-327)
      Gylfi Zoega

      Several papers published inMicroeconomic Foundations of Employment and Inflation Theoryin 1970 (Phelps et al. 1970) show why monetary policy cannot attain an arbitrary unemployment rate other than the natural rate of unemployment without generating rising inflation or deflation. However, even though the natural rate itself was never assumed to be a constant of nature in the volume—the Phelps (1970) paper in the volume makes it a function of the rate of growth of the labor force¹—modeling of the determinants of the natural unemployment rate only took off when economists were faced with a persistent elevation of...

    • CHAPTER TEN Imperfect Knowledge, Asset Price Swings, and Structural Slumps A Cointegrated Vector Autoregressive Analysis of Their Interdependence
      (pp. 328-350)
      Katarina Juselius

      The aim of this chapter is to discuss interactions between speculative behavior in the currency markets and aggregate activity in the real economy, inspired by the Structural Slumps theory in Phelps (1994) and the recent theory of Imperfect Knowledge Economics (IKE) in Frydman and Goldberg (2007). The former provides a coherent theoretical framework for how nonmonetary mechanisms can generate unemployment slumps in open economies connected by the world real interest rate and the real exchange rate, whereas the latter gives a rationale for why real exchange rates tend to fluctuate persistently around long-run benchmark values and why this is likely...

    • CHAPTER ELEVEN Stabilization Policies and Economic Growth
      (pp. 351-370)
      Philippe Aghion and Enisse Kharroubi

      Macroeconomic textbooks generally tend to present the analysis of long-term growth and the study of macroeconomic policies (e.g., fiscal and monetary policies) aimed at achieving short-run stabilization as distinct bodies of research. Indeed, the common wisdom among economists sees no connection between the way stabilization policies are implemented and the average speed at which the affected economy grows. If anything, growth theories tend to highlight the importance of stable and consistent policies as exemplified by recommendations to run prudent fiscal and monetary policies through balanced fiscal accounts or moderate inflation.

      Yet the view that policy recommendations to foster long-term growth...

  7. PART FOUR Policymaking after “Rational Expectations”

    • CHAPTER TWELVE Swings and the Rules-Discretion Balance
      (pp. 373-388)
      John B. Taylor

      I am honored to join in this fortieth anniversary of the Ned PhelpsMicroeconomic Foundationsvolume and to participate in this panel on rules versus discretion in economic policy during the past 40 years. Though I did not attend the January 1969 conference, my research on policy rules began around that time, so perhaps I can provide some historical perspective.

      Looking back at actual U.S. macroeconomic policy during this period, I see major swings in the balance between rules and discretion, first away from discretion toward rules-based policies and then back again toward discretion. I use the word “balance” to...

    • CHAPTER THIRTEEN Principled Policymaking in an Uncertain World
      (pp. 389-414)
      Michael Woodford

      A crucial legacy of Phelps et al. (1970) has been recognition of the importance of economic agents’ anticipations as a determinant of macroeconomic outcomes. This has had many profound consequences for macroeconomic analysis. Among them is that the subsequent theoretical literature on monetary policy has focused on the analysis of monetary policy rules rather than on decisions about individual policy actions. The present chapter considers the reasons for this development and the extent to which such a focus continues to be appropriate in the light of subsequent events—changes in central banks’ approach to monetary policy in the decades since...

    (pp. 415-420)
  9. INDEX
    (pp. 421-432)