ABSTRACT
John Muth began his classic article on rational expectations by noting that survey data on expectations were as accurate as the elaborate models of economists, and he noted that there were considerable differences of opinion in the crosssectional survey data (Muth, 1961). His basic insight was that economic agents form their expectations so that they are essentially the same as the predictions of the relevant economic theory. The assumption that expectations were formed rationally was, for Muth, the natural extension of economic theory, which already held that firms rationally maximize profits and consumers rationally maximize utility. Nonetheless, Muth noted that rationality was an assumption that could be tested by systematic comparison with alternative theories in explaining observed expectations. Muth’s hypothesis has indeed sparked an enormous amount of research, as well as wide divisions between disciplines, in how rationality should be conceptualized and how the hypothesis should be tested. Economics views rationality in terms of the choices it produces (substantive or full rationality), whereas other social sciences view rationality in terms of the process that is used to make choices (procedural or bounded rationality). It was Friedman’s (1953) celebrated essay on methodology that declared the validity of economic theories as independent of their psychological assumptions. Economists have accordingly focused on whether the postulate of unbounded or bounded rationality was the more productive theoretical construct in terms of its predictive accuracy. Compared with tests of utility maximization, expectations have the unique advantage that they can be measured and subjected to empirical tests.1 The rigor of the tests of the rational expectations hypothesis ranges from tests of bias and predictive accuracy to how efficiently every possible piece of relevant information is used in forming the expectations. There is a virtual absence of empirical tests of the assumptions surrounding utility maximization, including tests on whether agents gather and process the relevant economic information and use it efficiently to maximize utility, and whether consumers know all the relevant facts at any given time or if there is informational heterogeneity.
