Rational Expectations: Econometric Implications

It has long been recognized that forecasts affect outcomes. Similarly, outcomes affect expectations. Thus, there is a mapping from expectations to outcomes and back to expectations and so from expectations to expectations. A rational expectations equilibrium is a fixed point of this mapping in which expectations generate outcomes which confirm the original expectations. A rational expectations equilibrium is a natural solution concept in a model with expectations. The heuristic reasoning is that outside rational expectations equilibria agents make systematic mistakes; expectations are not confirmed by outcomes in that the expectations are not correct on the average. Consequently, it is very plausible that outside rational expectations equilibria, agents will eventually notice that they are making systematic mistakes and attempt to revise the way they forecast in order to eliminate the sources of the systematic errors. This suggests that agents are not in equilibrium until they have learned to form rational expectations.