Endogenizing government policy variables and synthesizing quantitative economic policy modeling and rational expectations hypothesis

Myung Joon Cha

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: The theory of quantitative economic policy (QEP) rationalizes the public policy process. It assumes all people, those in the private and in the public sectors, are rational, informed, and goal oriented. The QEP fails to account for effects of people's expectations of public policy choices upon their behavior. The rational expectations hypothesis (REH) assumes that economic agents in both public and private sectors have a good deal of information on economic events and form expectations of future events;Synthesizing QEP and REH involves endogenizing government policy variables. The synthesis casts doubt on the validity of some claims to conceptual superiority of the REH under the hierarchical information structure. The synthesis allows us to derive specification errors of treating policy instruments as exogenous rather than endogenous variables and also to revisit Lucas' critique of econometric policy evaluation and finds that when the public choices are endogenous, Lucas' critique is not applicable because the private sector can not form proper expectations about policy choices;Empirical study for 1954-1985 used Taylor's macroeconomic model of the United States to investigate effects of varying underlying assumptions on the synthesis and supports the claim that the endogenized policy variables should be included in government preference function because excluding them leads to unacceptable policy rules in economic sense. The numerical results show that prediction errors of quarterly money supply rules are smaller than those of annual money supply rules.

Date: 1987-01-01
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