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This chapter examines the central ideas about learning and bounded rationality for macroeconomics and finance. It first introduces the main methodological issues concerning expectation formation and learning before discussing the circumstances in which rational expectations may arise. It then reviews empirical work that applies learning to macroeconomic issues and asset prices, along with the implications of the use of structural knowledge in learning and the form of the agents' decision rules. As an application, the scope of Ricardian Equivalence is considered. The chapter also presents three applications of the learning approach to monetary policy: the appropriate specification of interest rate rules; implementation of price-level targeting to achieve learning stability of the optimal rational expectations equilibrium; and whether under learning, commitment to price-level targeting can be sufficient to rule out the deflation trap of a zero interest rate lower bound and return the economy to the intended rational expectations steady state.

This introductory chapter discusses the papers presented at the Center on Capitalism and Society conference held in the fall of 2010. The conference, which commemorated the fortieth anniversary of the Phelps microfoundations volume, featured researchers engaged in developing alternatives to the Rational Expectations Hypothesis (REH). The Phelps volume provided radically new accounts of the comovements of macroeconomic aggregates, including inflation and unemployment, while casting serious doubt on the validity of policy analysis based on then-popular Keynesian macroeconometric models. This chapter considers the various efforts to reinvent macroeconomics that were discussed at the Phelps conference, with a particular focus on non-REH alternatives and their implications for economic analysis. Topics include nonroutine change and imperfect knowledge, expectational coordination and market volatility, autonomous expectations in long swings in asset prices, and the natural rate of unemployment.

This chapter examines one line of criticism of the Rational Expectations Hypothesis (REH): expectational coordination failures. It begins by addressing the question of what went wrong with standard economic theory in general and with its modeling principles in particular and offers three answers relating to the diversification of modeling, the rationality hypothesis, and expectational coordination. It then considers the rise of REH in modern economic theory before discussing three avenues of criticism against REH: internal challenges, external criticisms, and criticism based on real-time learning. It also explains how a critical assessment of REH in different contexts changes the standard (REH-based) economic intuition, focusing on the question of the value of new financial instruments; the informational efficiency of the market; and the “good” expectational coordination that Real Business Cycles (RBC)-like models.

Discusses the main issues involved in practical applications of solution methods that have been proposed for rational expectations models, based on eigenvalue–eigenvector decompositions. It starts by reviewing how a numerical solution can be derived for the standard deterministic Cass–Koopmans–Brock–Mirman economy, pointing out the relevance of stability conditions. Next the general structure used to solve linear rational expectations models, and its extension to nonlinear models, is summarized. The solution method is then applied to Hansen's (1985) model of indivisible labour, and comparisons with other solution approaches are discussed. It is then shown how the eigenvalue–eigenvector decomposition can help to separately identify variables of a similar nature (as is the case when physical capital and inventories are inputs in an aggregate production technology), and how the solution method can be adapted to deal with endogenous growth models.

This chapter begins by examining the Lucas model (1973), the ‘down-to-earth’ (Phelps 1990:42) version of Lucas' (1972) pioneering article on Expectations and the Neutrality of Money. It then discusses some subsequent developments in new classical economics. It explains that new classical economics introduces rational expectations into macroeconomics. It notes that the rational expectations assumption is essential for policy effectiveness. It discusses that under rational expectations, wage setters take into account that the AD curve shifts outward. It clarifies that in order to achieve the target wage or employment level, they raise wages in such a way that the AS curve shifts to the left such that the intersection with the new AD curve occurs at the natural state of output.

This chapter examines the imperfect knowledge imperative in modern macroeconomics and finance theory. It argues that the Rational Expectations Hypothesis (REH) has nothing to do with how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. It attributes REH's insurmountable epistemological difficulties and widespread empirical problems to a single, overarching premise that underpins contemporary macroeconomics and finance theory: nonroutine change is unimportant for understanding outcomes. It also suggests that contemporary behavioral finance models rest on the same core premise as their REH-based counterparts. Finally, it introduces an alternative approach to modeling individual behavior and aggregate outcomes: Imperfect Knowledge Economics, which opens macroeconomics and finance models to nonroutine change and the imperfect knowledge that it engenders.

This chapter examines the methods adopted by British Prime Minister Margaret Thatcher and her French counterpart Raymond Poincaré to reduce the rate of inflation. Advocates of the two main groups of contemporary theories about inflation dynamics could have told Mrs. Thatcher that achieving that goal would be difficult. The first group consists of the “momentum” or “core inflation” theories, while the second group comprises the rational expectations-equilibrium theories. The chapter first provides an overview of the so-called Poincaré miracle before discussing Mrs. Thatcher's plan. It then considers the nature of the British government deficit, along with Britain's prospective revenues from North Sea oil that coincided with a simultaneous appreciation of the pound sterling. Finally, it compares Mrs. Thatcher's policies with respect to the coordination of monetary and fiscal policy with those of U.S. President Ronald Reagan.

This chapter discusses the rational expectations reconstruction of macroeconomics. In particular, it examines how the hypothesis of rational expectations has been used to develop econometric models that take into account that people's behavior patterns will vary systematically with changes in government policies—the rules of the game. The chapter looks at two examples that illustrate the general presumption that the systematic behavior of private agents and the random behavior of market outcomes both will change whenever agents' constraints change, as when government policy or other parts of the environment change. The first example deals with investment decision, and the second concerns the inflationary effects of government deficits. The chapter also considers the implications of the rational expectations approach for the ways in which policymakers and their advisers think about the choices confronting them.

The first of three chapters dedicated to the post-war period. Compares and contrasts the 'neoclassical synthesis' and the monetarist counter-revolution. Shows the rational expectation revolution as an offspring of Friedman's approach. Considers the non-Walrasian equilibrium theory and analyses the research programme of microfoundations of macroeconomics in some detail. Finally, assesses the post-Keynesian and new Keynesian approaches.

This chapter examines the connection between social power and domination. It is argued that an imbalance of social power is a necessary, but not sufficient condition of domination. Social power is analyzed as the ability of one person or group to change what another person or group would otherwise want to do. The relevance of strategies and rational expectations to a clear conception of power is considered and defended. It is also argued that power is not an essentially contested concept.

This chapter presents a real RBC-style model in which the interplay of real rigidities in the markets for credit and labor causes fluctuations. It also examines similar ideas in a monetarist-style model — which is un-new Keynesian in that it is not based on maximizing behavior and rational expectations. It investigates the effectiveness of monetary policy under rational expectations and staggered wage setting. Lastly, it evaluates a model with aggregate demand externalities.

Discusses models of information. Blackwells theorem in garbling and the value of information is proved. Monotonicity of decisions in signals is considered and related to supermodularity of the pay-off function and monotone likelihood ratio. Rational expectations equilibrium is discussed and existence of rational expectations equilibrium considered. Finally, equilibrium in abstract games of incomplete information is considered.

This chapter shows that predicaments facing the European Union today are reminiscent of constitutional decisions the United States faced not once, but twice. It begins with a simple expected present value model for government debt and explains how Hansen and Sargent (1980) used rational expectations econometrics to render this model operational. It then presents a case study that illustrates how the constitutions of the United States have influenced the government net-of-interest surplus process and therefore the value of government debt. Drawing on the unpleasant arithmetic of Sargent and Wallace (1981), the chapter argues that a responsible fiscal policy makes it easy for a monetary authority to sustain low inflation, whereas a profligate fiscal policy has the opposite effect.

Some practical issues are discussed that relate to the use of the parameterized expectations approach (PEA) for solving nonlinear stochastic dynamic models with rational expectations. This approach has been applied widely as it turns out to be a convenient algorithm, especially when there are large numbers of state variables and stochastic shocks in key conditional expectations terms. The first main section of the chapter provides a detailed discussion of some practical issues associated with the algorithm, and of its application. This is done using a set of examples—the Lucas asset pricing model, the simple stochastic growth model, and four variations of the latter, each selected to demonstrate a different issue. The next section describes a FORTRAN program used for implementing the algorithm, and the following one shows how it is applied to and adapted for each example previously presented.

This chapter examines several dramatic historical experiences that are consistent with the “rational expectations” view but that seem difficult to reconcile with the “momentum” model of inflation. The idea is to identify the measures that successfully brought drastic inflations under control in several European countries in the 1920s, namely: Austria, Hungary, Germany, and Poland, all of which experienced a dramatic “hyperinflation” in which, after the passage of several months, price indexes assumed astronomical proportions. The experience of Czechoslovakia is also considered. Within each of Austria, Hungary, Poland, and Germany, there occurred a dramatic change in the fiscal policy regime, which in each instance was associated with the end of a hyperinflation. Czechoslovakia deliberately adopted a relatively restrictive fiscal policy regime in order to maintain the value of its currency.

‘Multi-period Asset Pricing’ expands the analysis of asset prices to a multi-period economy, where an investor has to make consumption decisions in each period which may lead to consumption and wealth being different in the interim periods. The authors consider two distinct approaches to multi-period valuation; the time-state preference approach, where consumptions at different times and in different states were treated as separate assets, and the rational expectations approach that derives a period-by-period equilibrium in which investors form expectations of the price of securities. Here, they value assets relative to the value of bonds. While risk-free interest rate is given exogenously, the prices of these bonds at future points in time can be stochastic.