Rational Price Expectations and Small Macroeconomic Models

Abstract

<p>The purpose of this study was to analyze -- both theoretically and empirically -- the effects of various models of inflation expectations formation on aggregate supply relationships, and the small scale macroeconomic models of which they form an integral component, from the point of view of information availability, modelling, and estimation. One model of inflation expectations formation in particular, rational expectations, has important implications for macroeconomic modelling and, more specifically, the tradeoff between inflation and real output.</p> <p>The basic theory of rational expectations is reviewed and various problems with its empirical implementation are discussed. The properties of alternative models of expectations formation are compared. Furthermore, some direct evidence on the nature of expectations formation in active auction markets for financial instruments is presented.</p> <p>Expectations by their very nature are unobservable and thus one confronts a joint hypothesis problem in the interpretation of any results using a proxy specification. To circumvent this difficulty, Monte Carlo simulation experiments with a representative small macroeconomic model are undertaken. This allows a comparison between rational and other models of expectations formation under varying -- but known -- model conditions.</p> <p>Inherent in most models of expectations, and particularly for rational expectations, is the assumption that market participants possess a considerable degree of foresight with respect to information market structure, and parameter values. As an alternative, a time dependent approach to modelling with a minimum of information priors is developed and applications to real income, expected inflation and the demand for money are discussed.</p>