In a recent comment, however, ivansml pointed me to this very interesting paper from 2009, which I've enjoyed reading. What the paper does is explore what happens in some of the common rational expectations models if you suppose that agents' expectations aren't formed rationally but rather on the basis of some learning algorithm. The paper shows that learning algorithms of a certain kind lead to the same equilibrium outcome as the rational expectations viewpoint. This IS interesting and seems very impressive. However, I'm not sure it's as interesting as it seems at first.

The reason is that the learning algorithm is indeed of a rather special kind. Most of the models studied in the paper, if I understand correctly, suppose that agents in the market already know

*the right mathematical form*they should use to form expectations about prices in the future. All they lack is knowledge of the values of some parameters in the equation. This is a little like assuming that people who start out trying to learn the equations for, say, electricity and magnetism, already know the right form of Maxwell's equations, with all the right space and time derivatives, though they are ignorant of the correct coefficients. The paper shows that, given this assumption in which the form of the expectations equation is already known, agents soon evolve to the correct rational expectations solution. In this sense, rational expectations emerges from adaptive behaviour.

I don't find this very convincing as it makes the problem far too easy. More plausible, it seems to me, would be to assume that people start out with not much knowledge at all of how future prices will most likely be linked by inflation to current prices, make guesses with all kinds of crazy ideas, and learn by trial and error. Given the difficulty of this problem, and the lack even among economists themselves of great predictive success, this would seem more reasonable. However, it is also likely to lead to far more complexity in the economy itself, because a broader class of expectations will lead to a broader class of dynamics for future prices. In this sense, the models in this paper assume away any kind of complexity from a diversity of views.

To be fair to the authors of the paper, they do spell out their assumptions clearly. They state in fact that they assume that people in their economy form views on likely future prices in the same way modern econometricians do (i.e. using the very same mathematical models). So the gist seems to be that in a world in which all people think like economists and use the equations of modern econometrics to form their expectations, then, even if they start out with some of the coefficients "mis-specified," their ability to learn to use the right coefficients can drive the economy to a rational expectations equilibrium. Does this tell us much?

I'd be very interested in others' reactions to this. I do not claim to know much of anything about macroeconomics. Indeed, one of the nice things about this paper is its clear introduction to some of the standard models. This in itself is quite illuminating. I hadn't realized that the standard models are not any more complex than linear first-order time difference equations (if I have this right) with some terms including expectations. I had seen these equations before and always thought they must be toy models just meant to illustrate the far more complex and detailed models used in real calculations and located in some deep economic book I haven't yet seen, but now I'm not so sure.

(hope the comment goes through)

ReplyDeleteGlad you found the paper interesting. Unfortunately I'm not familiar with this area more closely, but George Evans has a lot more stuff about learning on his webpage.

Many micro-founded macroeconomic models (e.g. the basic real business cycle model of Kydland & Prescott) are nonlinear. But since we cannot solve nonlinear equations with forward-looking terms directly, often the equations are linearized around steady state of the economy, after which you obtain something like linear systems in the paper (and those can be solved relatively easily). This is usually good enough for some purposes, like computing standard deviations and correlations of variables predicted by your model, or plotting their responses to random shocks. There are also methods to obtain nonlinear approximations, but they're bit more complicated.

There certainly exist more complicated macroeconomic models, especially those used for quantitative purposes (e.g. in central banks). At the same time, many models published by academics are more theoretical and abstract in nature, so they will typically focus on single idea and simplify everything else - those can be called "toy" models (which is not a bad thing, as long as everyone understands their purpose).