Kenneth Arrow on rational expectations and microfoundations

23 Jul, 2012 at 21:39 | Posted in Economics, Theory of Science & Methodology | 1 Comment

One of the greatest economists of all time – Kenneth Arrow – made an assessment of microfoundations and rational expectations in an article – in Journal of Business (1986) – entitled Rationality of Self and Others in an Economic System. It ought to be mandatory reading for all students of “modern” macroeconomics:

[The power of both “new classical” and “rational expectations models”] is obtained by adding strong supplementary assumptions to the general model of rationality. Most prevalent of all is the assumption that all individuals have the same utility function … But this postulate leads to curious and, to my mind, serious difficulties in the interpretation of evidence … [I]f all individuals are alike, why do they not make the same choice? Why do we observe a dispersion? … Analogously, in macroeconomic models … the assumption of homogeneous agents implies that there will never be any trading, though there will be changes in prices.

This dilemma is intrinsic. If agents are alike, there is really no room for trade. The very basis of economic analysis, from Smith on, is the existence of differences in agents …

The new theoretical paradigm of rational expectations holds that ach individual forms expectations of the future on the basis of a correct model of the economy, in fact, the same model that the econometrician is using … Since the world is uncertain, the expectations take the form of probability distributions, and each agent’s expectations are conditional on the information available to him or her …

Each agent has to have a model of the entire economy to preserve rationality. The cost of knowledge, so emphasized by the defenders of the price system as against centralized planning, has disappeared; each agent is engaged in very extensive information gathering and data processing.

Rational expectations theory is a stochastic form of perfect foresight. Not only the feasibility but even the logical consistency of this hypothesis was attacked long ago … Rational expectations … require not only extensive first-order knowledge but also common knowledge, since predictions of the future depend on other individuals’ predictions of the future.

1 Comment

  1. “The very basis of economic analysis, from Smith on, is the existence of differences in agents.”

    It’s a stronger statement than the Lucas critique. I wish I had read that when I was studying economics.

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