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Uncertainty, Expectations, and Financial InstabilityReviving Allais's Lost Theory of Psychological Time$
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Eric Barthalon

Print publication date: 2014

Print ISBN-13: 9780231166287

Published to Columbia Scholarship Online: November 2015

DOI: 10.7312/columbia/9780231166287.001.0001

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Rational Expectations Are Endogenous to and Abide by “the” Model

Rational Expectations Are Endogenous to and Abide by “the” Model

(p.17) Chapter Two Rational Expectations Are Endogenous to and Abide by “the” Model
Uncertainty, Expectations, and Financial Instability

Eric Barthalon

Columbia University Press

This chapter examines the main assumptions of the rational expectations hypothesis (REH). REH is a pillar of the neo-Walrasian approach to general equilibrium, a mathematically demanding theory purporting to show how the interaction between rational agents engaged in constrained maximization of consumption, production, profits, etc., over time, generates a unique and stable intertemporal equilibrium. This chapter first provides a historical overview of REH before discussing John Muth's critique of exponential averages as a forecasting technique and his claim that exponential smoothing is an optimal filtering method, along with his other arguments against adaptive expectations. It then considers the application of REH to macroeconomics and proceeds by analyzing some of the criticisms against REH, including the mathematical or computational difficulties present in RE models and the compatibility of RE models with empirical data. Finally, it highlights REH's limited methodological relevance when it comes to modeling observed economic behavior.

Keywords:   rational expectations hypothesis, general equilibrium, rational agents, John Muth, exponential averages, exponential smoothing, adaptive expectations, macroeconomics, empirical data, economic behavior

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