Mike Woodford: why we need to model expectations realistically

I just read an essay by Mike Woodford from 2012, and I thought I might pass on a few interesting observations he made. He was responding to a criticism of rational expectations based DSGE  modelling made by John Kay. What he says seems to make quite a bit of sense to me, especially about the need to model how people form expectations in a realistic way, going beyond the naive assumption of rational expectations, looking to empirical evidence instead (those comments come toward the end):

"There is... an important respect in which I do believe that much model-based economic
analysis imposes a requirement of internal consistency that is unduly strong, and that may result in unnecessary fragility of the conclusions reached; and I suspect that this has a fair amount to do with the unease that Kay expresses about modern economic analysis. It has been standard for at least the past three decades to use models in which not only does the model give a complete description of a hypothetical world, and not only is this description one in which outcomes follow from rational behavior on the part of the decision-makers in the model, but the decision-makers in the model are assumed to understand the world in exactly the way it is represented in the model.

This postulate of “rational expectations,” as it is commonly though rather misleadingly known, is the crucial theoretical assumption behind such doctrines as “efficient markets” in asset pricing theory and “Ricardian equivalence” in macroeconomics. It is often presented as if it were a simple consequence of an aspiration to internal consistency in one’s model and/or explanation of people’s choices in terms of individual rationality, but in fact it is not a necessary implication of these methodological commitments. It does not follow from the fact that one believes in the validity of one’s own model and that one believes that people can be assumed to make rational choices that they must be assumed to make the choices that would be seen to be correct by someone who (like the economist) believes in the validity of the predictions of that model. Still less would it follow, if the economist herself accepts the necessity of entertaining the possibility of a variety of possible models, that the only models that she should consider are ones in each of which everyone in the economy is assumed to understand the correctness of that particular model, rather than entertaining beliefs that might (for example) be consistent with one of the other models in the set that she herself regards as possibly correct."

"...the mainstream alternative developed in response to [the Lucas] critique --- according to which aggregate consumer expenditure is modeled as the solution to the Euler equation (a condition for intertemporal optimality) of a representative household, under the hypothesis of rational expectations, has difficulty matching the statistical properties of aggregate data too closely. In order to avoid making strongly counter-factual predictions, current-vintage empirical DSGE models commonly assume preferences for the representative household that incorporate a high degree of “habit persistence,” so that even when solved under the assumption of intertemporal optimization under rational expectations, consumer spending will not jump sharply in response to events that (at least according to the model) should predictably change the future path of household income. But the postulate of strong habit persistence has not found much support from studies of the behavior of individual households. An alternative explanation for the observation of persistent departures from the predictions of the rational expectations Euler-equation model under more standard preferences would be the existence of persistent departures of actual household expectations from those implied by the rational-expectations solution of the economists’ model."

"The macroeconomics of the future, I believe, will... have to go beyond conventional late-twentieth-century methodology as well, by making the formation and revision of expectations an object of analysis in its own right... A prudent use of such an approach for economic policy analysis would surely need to consider a variety of possible assumptions about the forecasting approaches used by economic agents, quite apart from the consideration that would be given to uncertainty about the correct specification of the economic environment.

This absence of a single clear prediction about how people should forecast is often considered to be a reason not to entertain such hypotheses, and instead to prefer the hypothesis of rational expectations, which aims to provide a unique prediction about expectations in a given economic environment. But a more sensible approach may be to accept that one should only expect one’s model of the economy to deliver a range of plausible outcomes, rather than a unique prediction...

Allowance for a set of possible outcomes under a given policy would lead to an approach to policy design that would focus on the robustness of policy to possible variations in the way that the consequences of the policy are understood by people in the economy, rather than focusing solely on the optimality of the policy if events unfold precisely as planned. It should lead, for example, to a concern to design policies that make it more difficult for asset bubbles to occur, or that should reduce the economic distortions that result from them when they do occur, rather than ignoring these issues on the ground that in a rational-expectations equilibrium the bubbles should not occur. It should also lead to greater attention to the communication policies of central banks and other governmental actors, rather than assuming that official explanations of policy are irrelevant given that economic agents can be expected to have rational expectations --- and that these “rational” expectations depend only on governmental actions, not upon speech."

"... What we should outgrow... is the aspiration to build models that can not only be regarded (at least provisionally) as correct representations of reality for purposes of policy analysis, but that can be assumed to be self-evidently valid to everyone in the economy as well."

From "What’s Wrong with Economic Models?", Michael Woodford, July 2012
http://ineteconomics.org/sites/inet.civicactions.net/files/Note-9-Woodford.pdf