Rational Expectations

Expectations have been a central issue in macroeconomics

from the very foundation of the subject;

'we must remember that the price of capital goods varies not
only by reason of past changes but also by reason of
expected changes either in gross income or in rates of
depreciation and insurance' Walras (1954)p310.

Much early empirical work on expectations centred around

attempts to provide direct measures of agents expectations,
eg Katona(1951, 1958), Tobin(1959) or Eisner(1965), and the
thrust of much of this research was towards a psychological
understanding of individual expectations formation.
The adaptive expectations hypothesis by Cagan(1956) and
Nerlove(1958), was an important departure because it allowed
the treatment of expectations to be made explicit.

Background To Expectations Mechanisms

The hypothesis of adaptive expectations, first proposed by

Cagan (1956),

( t -1 x - x ) = ( xt -1 -t - 2 x )
e
t t -2
e
t -1
e
t -1 0 < <1
By simply rearranging this we can get,

( t -1 x ) = xt -1 + (1 - )t - 2 x
e
t
e
t -1

and

( t -1 x ) = xt -1 + (1 - ) xt -2 + (1 - ) xt -3 . . .
e 2
t

and so we may model the unobservable expectation purely in

terms of past observations of x.
However this model may not always give a sensible result

expectation

In this case it does

But if the data is trended???

expectation

The expectation always goes to the mean

Muth (1961) introduced the notion of a rational expectation to be
'Essentially the same as the prediction of the relevant economic
theory'.

This would rule out the adaptive expectations model in many

circumstances as being a sensible way to form expectations

A rational agent can not make consistent and predictable mistakes

The Lucas critique (Lucas 1976) essentially emphasised the
idea that policy regimes and particular policy rules will affect
the reduced form solution for all the endogenous variables in
a model. And hence the expectations of a rational agent

Suppose a government controls an instrument G and that

agents want to form expectations about a variable X, which is
simply the sum of G and Z,

X t = Gt + Z t
And

Z t = X t + t
Now under one regime where G is simply held fixed a
reasonable expectations rule to form expectations about the
future value of X would simply be,

e
)= G t+1
(t X
1-
t+1

The rule for G is known so agents know Gt+1. An equally good

way to forecast X would simply be based on;

e
(t X t +1 )= X t
Suppose the government changed its policy rule and decided
that from now on G would grow at 10% per period. The first
equation would still be a valid approach, but the second is no
longer appropriate as the growth in G would now imply that

e
(t X t+1 ) = 1.1X t
So the model which uses the structure of the system remains
unchanged when the policy rule changes.

But the time series (adaptive) model is structurally unstable

The main disadvantage of the RE approach is the extreme
assumption which is required about the information available
to the economic agent.

An alternative approach to making this extreme assumption

would be to assume that agents' expectations are on average
correct but not make any specific assumption about how
agents arrive at these expectations.

We must therefore move to a class of models which, while

not containing full information, are able to adapt to regime
changes and in effect to 'learn' about the economic
environment.
The question of learning is also important in the context of
the RE assumption where, in particular, the question of how
agents come to know the true model is simply not addressed.

The most extreme assumption, underlying much of the earlier

theoretical literature, gives rise to the rational learning
models, Friedman(1975), Townsend (1978, 1983), Bray(1983),
Bray and Kreps (1984) or Frydman (1982).

A slightly weaker assumption gives rise to the boundedly

rational learning models.
Recently however we have come to appreciate that the
behaviour of the parameters in the learning rule gives an
important insight into the form of equilibria which may
emerge from the system. Marcet and Sargent(1988)

So suppose an agent has a rule which is a linear function of a

set of parameters D and the learning process (assumed to be
some form of least squares learning) is represented by a
mapping S, such that Dt+1 = S(Dt).

A fixed point of the mapping is represented by convergence

of this sequence to some fixed value, this point is sometimes
referred to as an expectations equilibrium or an E-
equilibrium.

Marcet and Sargent(1989a) demonstrate that this fixed point

is also a full rational expectations equilibrium.
Econometrics and RE

The basic axioms of RE

If agents are rational they act on all information in the most

efficient way. Forecasts are unbiased, uncorrelated and
efficient
Then if x x
t 1 t
e
t 1 t+1

RE implies
E( t+1 | t ) = E( t+1 | t ) = 0
E( | ) =
2
t +1
2

E( t+1 t+1- j ) = 0 j > 0

However the k step ahead RE forecast is correlated with the k-1 step
ahead forecast, eg

if

xt+1 = xt + et
so xt+k = xt + et+1 + ...+ et+k
k

and so

e
xt+1 -t x = et+1
t +1
e
xt+2 -t xt+2 = et+1 + et+2
The one step ahead forecast is independent white noise but
further ahead forecasts are correlated, although all are
independent of the information set.

The change in expectations between one period and the next

depends only on the arrival of new information.

e
( t+1 x - x
t+ j t
e
t+ j ) = f( t+1 - t )
Direct tests of RE

If some measure of expectations exists then a direct test

generally takes the form

xt+1 = 0
+ ( e
1 t xt +1
) + 2 t + t
where H 0 : 0 = 0 = 2 , 1 = 1

If the expectation is more than one period ahead then the

error term will be MA(k-1)

x t +k = 0 + 1 ( t x ) + 2 t + t
e
t +k

where H 0 : 0 = 0 = 2 , 1 = 1
but t = 0 et + 1 et -1 + ... k et - k
This presents problems of inference and much attention has
been devoted to constructing correct tests for this case.
Much financial data often contains this problem especially eg
monthly data on three month rates of return.

Multi period expectations

Many models also generate theoretical reasons for expecting

multi period expectations.

eg the Sargent(1979) adjustment cost model

Suppose agents have a desired target Y* and they chose Y

but changing Y rapidly is costly. We can represent this as,

Min C = E[ D ( a0 ( Y t+i - Y
i * 2 2
t +i ) + a1 ( Y t+i - Y t+i -1 ) )]
i=0

the FOC for this are

2( a0 ( Y t+i - Y *t+i ) + a1 ( Y t+i - Y t+i-1 ) - a1 ( Y t+i+1 - Y t+i )) = 0

1*
( +
Y t+i a0 a1 (-L + L )) = a0 Y t+i

and the general solution to this is

Y t+i = 1 Y t+i -1 + (1 - 1 )(1 - 1 D) ( 1 D ) Y
k -i *
t +i+k
k =i
An illustrative example
suppose we have a model

Y t = 1( t X )+ 2 ( t X
e e
t +1 t +2 ) + ut
under RE we have,

xt+i =t x + t+i
e
t+i
and so

Y t = 1( X t+1 ) + 2 ( X t+2 ) + ut - 1 t+1 - 2 t+2

Now the Xs are correlated with the error term and there is an
MA(2) error process. This is the general problem created by
RE estimation.
We could do FIML estimation if we had a model for X, but this
is expensive and often not robust. a much more common way
of dealing with these problems is the Errors in Variable (EVM)
approach.

The Error in Variable approach

This is a form of instrumental variable estimation which

allows for the measurement error of using actual to replace
expected variables.
IV and 2 step estimators

suppose we have a model

Y t = 1( t X ) + 2 ( X t,2 ) + u t
e
t +1,1

we proceed by replacing the expectation of X1 with its actual

value, we can then perform instrumental variable estimation
using X2 and any other suitable instruments. or we can do a
2-step estimator.

X t+1,1 = ( x2 ,other instruments)

and then

Y t = 1( X t+1,1 ) + 2 ( X t,2 ) + ut
This is all an instrumental variable estimator is except that
the IV estimator does the process in one go. The two will give
identical estimates for the parameters but different standard
errors and `t' statistics as the IV estimator uses

ut = Y t - 1( X t+1,1 ) - 2 ( X t,2 )
To calculate the SE while the 2 step procedure uses the
instrumenting variable
Extrapolative predictors

Often when we only have expectations of exogenous

variables we construct expectations series from lagged data
(eg a subsidiary VAR system).

( t X te+1 ) - t+1 = X t+1 = (L) xt + t

These are extrapolative predictors. Given the Chain Rule of
Forecasting we may use this equation to make multi period
ahead forecasts.

( t X t+2 ) = (L)[(L) xt ]
e

note if X2 Granger causes X1 then as we have left X2 out of the

extrapolative model the parameters will be biased.
Serially Correlated errors

RE naturally gives rise to MA errors in overlapping data

models, many approaches have been developed to cope with
this.

Hansens GMM method

This uses GMM (or equivalently IV) to estimate the structural
equation,

suppose we have a model

Y t = 1( t X )+ 2 ( t X
e e
t +1 t +2 ) + ut
under RE we have,

xt+i =t x + t+i
e
t+i
and so

Y t = 1( X t+1 ) + 2 ( X t+2 ) + ut - 1 t+1 - 2 t+2

IV or GMM will yield consistent estimates of the parameters

(this is just an application of Quasi Maximum Likelihood) but
the standard errors are biased so we can not undertake
conventional tests.
Hansen and Hoderick proposed a correction to the standard
errors, define

et = Y t - 1( X t+1 ) + 2 ( X t+2 )
Now the corrected covariance in the presence of an MA(2)
error process will be
1 1 0 0 ... 0

1 1 1 0 ... 0

E(ee) = 2 0 1 1 1 ... 0 = 2

. . .

0 0 ...0 1 1
where
T
ei /T
=2 2

i=1
T
1=[ ei ei -1 ]/T
2

i= 2
and

VAR( ) = (X X ) (X X)(X X )
2 -1 -1
Newey West

The Hansen Hoderick robust estimators are asymptotically

correct but in a small sample they may give rise to an
estimate of the covariance matrix which is not positive semi-
definite, ie it can not be inverted.

Newey and West suggested a correction to the HH estimate

which ensures positive semi definiteness even in small
samples. The Newey West correction is
T
= ei2 /T
2

i=1
T
j=[ w(j,m)e e
2
i i- j ]/T j=1...m
i= j+1

w(j,m) = 1 - [j/(m + 1)]

Hayashi-Sims

A more efficient method would be to actually estimate the

moving average parameters rather than to simply estimate
using OLS or simple IV. The GLS transformation is usually to
lag all the variables so that the error term is transformed to
white noise. Consider

Y t = 1 ( X t+1 ) ut 1 ut -1

we would normally transform this so that

Y t (1 - 1 L ) = (1 - 1 L ) [ 1( X t+1 ) + 2 ( X t+2 )] + ut
-1 -1

The problem here is that this would transform the model so

that the lagged variables were no longer orthogonal to the
error term.
Hayashi and Sims suggest a forward filtering process which
maintains orthogonality and removes the serial correlation.

Yt (1 +1L )
-1 -1
= (1 + 1 L ) 1 X t+1 2 X t+2
-1 -1
[ ( ) + ( )] + *
ut
The Cumbey (1983) 2-step, 2-Stage LS

A more efficient estimator can be achieved by performing a

generalised form of IV which takes account both of the
simultaneity and the MA error.

If y = x + q

E(q q) = plim( T (xq))NE0
2 -1

then the 2S2SLS estimator is

2 = [xV(V V ) V x ] [xV(V V ) V y]
-1 -1 -1

var( 2 ) = [xV(V V ) V x )
2 -1 -1
Cross Equation Restrictions

Our model generally consist of a structural equation and a

subsidiary model to generate the expectations terms (an AR
model, a VAR or an implicit model in the Instruments). Often
there may exist cross equation restrictions between the
marginal model and the structural model.
Y t 1 t X t+1 ) + ut
e
= (
Suppose
X t+1 = (L)X t 1 + vt
then we could write this system as

Y t = 1 ( (L) X t -1 ) + u t + 1 vt
X t+1 = (L) X t -1 + vt
Testing this restriction then entails a joint test of the model
and the RE assumption.
The Importance of Expectations

In empirical work expectations have proved enormously

useful

Perhaps the most striking example of such an area of

positive achievement is the exchange rate.

The emerging consensus rests on the use of the uncovered

arbitrage relationship.

et = 1(L) et+1 + 2 (L)( r t - r tf ) + 3 (L) zt

Estimation of this form of relationship may be found in
Hall(1987a, 1987b), Currie and Hall(1989), Gurney, Henry and
Pesaran(1989), Fisher et al(1990), Hall(1992) and Hall and
Garratt(1992).
Time Inconsistency

A closely related problem to the informational problem

outlined above is the problem of time inconsistency

These issues may be formalised by following the simple

illustration of Kydland and Prescott, state a general welfare
function for two periods as,

S( x1 , x2 , 1 , 2 )
x1 = X 1( 1 , 2 )

x2 = X 2 ( x1 , 1 , 2 )
Now if we derive the first order condition for policy in period
2 from the standpoint of a policy maker in period 1 we get,

S x2 S S x1
. + + . =0
x2 2 2 x1 2

Now if we consider the first order conditions in period 2,

assuming everything occurred in period 1 as originally
planned, the conditions become.
S x2 S
. + =0
x2 2 2
Which is clearly different
Non-Linearities and Expectations

The usual hypothesis which underlies both the RE

assumption and the analysis of linear models is that agents
take the mathematical expectation of the relevant model as
their measure of expectations.

A further complication which arises in non-linear models is

that generally the deterministic solution to the model will not
be the mathematical expectation of the probability
distribution of the stochastic model.

Ef( yt ) f(E( yt ))
So the expected value of the sterling dollar exchange rate does
not equal 1/ the expected value of the dollar sterling rate.

E ( / $) 1 / E ($ / )

Hall(1988) argues that many apparent contradictions which

arise because of non-linearitys may be reconciled by using
the median as the relevant measure of expectations along
with suitable distributional assumptions.
 If there is a direst measure of the expected
exchange rate (S) such as the forward rate (F)
then
S-F should be unforecastable white noise

But overlapping data (weekly observations on

three month forward rates) creates a moving
average error.

They propose estimating by a consistent

technique (OLS sometimes or GMM)
Then correcting the standard errors with the HH
correction
This table tests using only two lagged dependent variables

One significant
result
This table Test using lagged cross rates from all markets

More significant
results
But now shorten the period to exclude the 1973 oil price crises

Less significant
number of results
Testing using more cross rates
Some increase
in significance
Now consider data from the 1920s
Lots of significant
results