Rational Expectations - Criticisms

Criticisms

The models of Muth and Lucas (and the strongest version of the efficient-market hypothesis) assume that at any specific time, a market or the economy has only one equilibrium (which was determined ahead of time), so that people form their expectations around this unique equilibrium. Muth's math (sketched above) assumed that P* was unique. Lucas assumed that equilibrium corresponded to a unique "full employment" level (potential output) -- corresponding to a unique NAIRU or natural rate of unemployment. If there is more than one possible equilibrium at any time then the more interesting implications of the theory of rational expectations do not apply. In fact, expectations would determine the nature of the equilibrium attained, reversing the line of causation posited by rational expectations theorists.

A further problem relates to the application of the rational expectations hypothesis to aggregate behavior. It is well known that assumptions about individual behavior do not carry over to aggregate behavior (Sonnenschein-Mantel-Debreu theorem). The same holds true for rationality assumptions: Even if all individuals have rational expectations, the representative household describing these behaviors may exhibit behavior that does not satisfy rationality assumptions (Janssen 1993). Hence the rational expectations hypothesis, as applied to the representative household, is unrelated to the presence or absence of rational expectations on the micro level and lacks, in this sense, a microeconomic foundation.

It can be argued that it is difficult to apply the standard efficient market hypothesis (efficient market theory) to understand the stock market bubble that ended in 2000 and collapsed thereafter; however, advocates of rational expectations say that the problem of ascertaining all the pertinent effects of the stock-market crash is a great challenge.

Furthermore, social scientists in general criticize the movement of this theory into other fields such as political science. In his book Essence of Decision, political scientist Graham T. Allison specifically attacked the rational expectations theory.

Some economists now use the adaptive expectations model, but then complement it with ideas based on the rational expectations theory. For example, an anti-inflation campaign by the central bank is more effective if it is seen as "credible," i.e., if it convinces people that it will "stick to its guns." The bank can convince people to lower their inflationary expectations, which implies less of a feedback into the actual inflation rate. (An advocate of Rational Expectations would say, rather, that the pronouncements of central banks are facts that must be incorporated into one's forecast because central banks can act independently). Those studying financial markets similarly apply the efficient-markets hypothesis but keep the existence of exceptions in mind.