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The Rational Expectations Hypothesis: An Assessment from Popper's Philosophy

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  • Ivan H. Ayala
  • Alfonso Palacio-Vera
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    Abstract

    The rational expectations hypothesis (REH) is the standard approach to expectations formation in macroeconomics. We discuss its compatibility with two strands of Karl Popper's philosophy: his theory of knowledge and learning, and his "rationality principle" (RP). First, we show that the REH is utterly incompatible with the former. Second, we argue that the REH can nevertheless be interpreted as a heuristic device that facilitates economic modeling and, consequently, it may be justified along the same lines as Popper's RP. We then argue that, our position as to the resolution of this paradox notwithstanding, Popper's philosophy provides a metatheoretical framework with which we can evaluate the REH. Within this framework, the REH can be viewed as a heuristic device or strategy that fulfils the same function as, for instance, the optimizing assumption. However, we believe that the REH imparts a serious methodological bias, since, by implying that macroeconomic instability is caused exclusively by "exogenous" shocks that randomly hit the economy, it precludes the analysis of any sources of inherent instability caused by the making of (nonrandom) errors by individuals, and hence it favors the creation of an institutional configuration that may be ill suited to address this type of instability.

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    Paper provided by Levy Economics Institute in its series Economics Working Paper Archive with number wp_786.

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    Date of creation: Jan 2014
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    Handle: RePEc:lev:wrkpap:wp_786

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    Related research

    Keywords: Popper; Knowledge; Rational Expectations; Learning; Trial; Error Elimination;

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    1. Michael Woodford, 2009. "Convergence in Macroeconomics: Elements of the New Synthesis," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(1), pages 267-79, January.
    2. Richard R. Nelson & Sidney G. Winter, 2002. "Evolutionary Theorizing in Economics," Journal of Economic Perspectives, American Economic Association, vol. 16(2), pages 23-46, Spring.
    3. Caldwell, Bruce J, 1991. "Clarifying Popper," Journal of Economic Literature, American Economic Association, vol. 29(1), pages 1-33, March.
    4. Arrow, Kenneth J, 1978. "The Future and the Present in Economic Life," Economic Inquiry, Western Economic Association International, vol. 16(2), pages 157-69, April.
    5. Paul Davidson, 1991. "Is Probability Theory Relevant for Uncertainty? A Post Keynesian Perspective," Journal of Economic Perspectives, American Economic Association, vol. 5(1), pages 129-143, Winter.
    6. Hands, Douglas W., 1985. "Karl Popper and Economic Methodology: A New Look," Economics and Philosophy, Cambridge University Press, vol. 1(01), pages 83-99, April.
    7. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
    8. Friedman, Benjamin Morton, 2011. "Reconstructing Economics in Light of the 2007-? Financial Crisis," Scholarly Articles 5241348, Harvard University Department of Economics.
    9. Joseph E. Stiglitz, 2011. "Rethinking Macroeconomics: What Failed, And How To Repair It," Journal of the European Economic Association, European Economic Association, vol. 9(4), pages 591-645, 08.
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