The Trouble with Rational Expectations in Heterogeneous Agent Models: A Challenge for Macroeconomics

Benjamin Moll

No 19731, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: The thesis of this essay is that, in heterogeneous agent macroeconomics, the assumption of rational expectations about equilibrium prices is unrealistic, unnecessarily complicates computations, and should be replaced. This is because rational expectations imply that decision makers (unrealistically) forecast equilibrium prices like interest rates by forecasting cross-sectional distributions. The result is an extreme version of the curse of dimensionality: dynamic programming problems in which the entire cross-sectional distribution is a state variable ("Master equation" a.k.a. "Monster equation"). This problem severely limits the applicability of the heterogeneous-agent approach to some of the biggest questions in macroeconomics, namely those in which aggregate risk and non-linearities are key, like financial crises. This troublesome feature of the rational expectations assumption poses a challenge: what should replace it? I outline three criteria that alternative approaches should satisfy: (1) simplification of the computational solution, (2) consistency with empirical evidence, and (3) (some) immunity to the Lucas critique. I then discuss some potentially promising directions, including temporary equilibrium approaches, incorporating survey expectations, least-squares learning, and reinforcement learning.

JEL-codes: E00 (search for similar items in EconPapers)
Date: 2024-12
References: Add references at CitEc
Citations:

Downloads: (external link)
https://cepr.org/publications/DP19731 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:19731

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP19731

Access Statistics for this paper

More papers in CEPR Discussion Papers from Centre for Economic Policy Research 33 Great Sutton Street, London EC1V 0DX, UK.
Bibliographic data for series maintained by CEPR ().