Expectations are a key concept in economics. If expectations are coordinated, then the economy is equilibrated and no accumulation of imbalances take place. Rational expectations, more particularly, sustain that even though errors are possible, they shouldn’t be systematic. Namely, a given agent does nos systematically repeat his mistake, and all agents cannot be fooled on the same direction. Therefore, given rational expectations, monetary policy cannot produce business cycles other than by an unexpected monetary shock. Rational economic agents, however, should not be fooled by a continued and publicly known monetary policy. There are, however, a few reasons why monetary policy can have an effect on the economy through its effects on (rational) expectations.
First, expectations are not pure mechanical process, but the result of a subjective interpretation of market information. Different agents with different theories and points of view can interpret the same information differently. The difference of opinion on the causes of the Great Depression between an austrian, a monetarist and a keynesian is not due to lack of information, but to a different understanding of the market process. Expectations are not only, rational, but also subjective. An unsound monetary policy that is mistakenly considered to be sound by economic agents and policy makers can produce systemic errors. Rational expectations assume a model, but the behavior of rational expectations in one given model can result in a crisis in a different model. Since the real world can be interpreted by more than one model agents with different expectations can produce a cluster of errors in the market.
Second, besides the exogenous characteristic of expectations, they also have an endogenous behavior. Expectations are something that the economic agents produce and bring into the model, in that sense expectations are exogenous. But expectations are not created in a vacuum, but using market information (i.e. prices and interest rates). Therefore, an analysis of the effects of monetary policy and expectation cannot start and stop on expectations. It needs to make a step forward and analyze the effect that any given policy will have on market prices and from there what the effects will be on the agents expectations. Since the equilibrium condition are unknown, any given agent can’t be sure whether or not his expectations were correct or wrong. For instance, a monetary policy that artificially lowers interest rates confirms the mistakenly low expectations on the part of too optimistic economic agents. In addition, the low interest rate becomes the endogenous input that economic agents use to form expectations. The result can be biased expectations, not because economic agents are irrational, but because the market data is distorted and the equilibrium, conditions are unknown.
Third, if the market process if a complex phenomenon, meaning that is too complex for the human mind to envision all of its aspects, then rational expectations beg the question of where the knowledge of the correct model of the world comes from. If the market process is too complex for the economic agents rationality, then it is also too complex for the rational expectations. A formal model, however, presents a different scenario. In a formal model the economist knows everything that is to be known about that market, and so economic agents can rationalize the model. This simplifications of the models can be useful to analyze some cases, but it is misleading to use the results of rational expectations in simple models to criticize theories that do not simplify the market, but allow for a complex phenomenon (i.e. the Mises-Hayek business cycle theory).
These difficulties does not mean that economic agents are irrational, but that there are some arational characteristics of expectations they may not be less important that the rational content. Expectations are not only also subjective, but there is a limit to how much economic agents can rationalize on their expectations: (1) distorted market prices, not equilibrium conditions, are a key input in the process of expectations formation and (2) the market is too complex to be completely rationalized by the economic agent.
Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.