models in economic theory

The Aggregated Expectations Hypothesis offers a new way of examining likely future outcomes, based upon the most important contributor - expectations - to the individual decisions which aggregate to create these final macro-outcomes. It also offers the more powerful actors, especially governments, a new tool for influencing some of those future outcomes. One outcome is that (economic) models should be viewed primarily as communications devices. Their power depends upon how well they persuade the actors, on whom they are targeted, to bring their behaviour into line with that incorporated in the model.

In the Rational Expectations Hypothesis the emphasis has most often been placed on the first and last words; with expectations accordingly used in a tightly defined context. The key assumption, as in much of recent economics, is that the actor/agent - usually in a financial market, but almost always influential in macro-economic outcomes [Svennson, 1996] - is rational. Indeed, use of rational expectations theory is based upon the actions of the informed actors (who are usually quite limited in number) most directly influencing macro-economic outcomes. Further, development of the hypothesis is (mathematically) rigorous, and the outcomes are determined by the exact form of the equations chosen for the model. Indeed, based upon Lucas’s [1973] original work, which took Muth’s [1961] work in a single market and extended it to macro-economic models, the many subsequent developments have typically revolved around the details of the mathematics involved. In this context, therefore, the models are directly related to the economic forces involved.

The ‘general hypothesis of aggregated expectations’, on the other hand, however, does not assume a rational actor, and typically looks to the very much larger number of uninformed, though not necessarily irrational, participants throughout the whole population.

In economic theory, the problem of limited information - which is seen by some economists as a limitation on rational behaviour - has been most directly addressed by the body of work which has developed - especially under the theories of transaction costs - from Simon’s [1957] original suggestion that (economic) decisions might be based upon ‘bounded rationality’. Recently, this concept has also been applied (for instance by Sargent [1995]) to the rational expectations hypothesis; to allow for multiplicity of equilibria in a dynamic environment (especially where there are regime changes). Even so, some critics have protested that the hypothesis breaks down under the complexities and uncertainties imposed by real world economics [Shaw, 1987] and research results indicate that managers, for instance, fail even the weakest possible tests of rationality [Anderson and Goldsmith, 1994].

Management practice, on the other hand, has taken a more pragmatic approach, looking to alternative forecasts, typically using the scenario planning processes; which derive from ‘soft’ practical judgements about the future (usually on the basis of experience) rather than the ‘hard’ theoretical equations favoured by many economists. Scenario planning techniques have been most extensively developed by Shell Oil [Wack, 1985 and Schwartz, 1991], with whom we worked, to develop the basic research techniques which support our work.

The future outcome of a (macro) issue - economic or political - will be largely determined by the expectations of those, in the population affected, whose aggregated individual decisions will shape that outcome.

The corollary is that changing the expectations of this population will change the (macro) outcome.

The outcome will be decided by many individual decisions[1], such that no one such single decision will unduly affect the overall aggregate decision.

The outcome will not be unduly constrained by any resource scarcity, or bottle-neck.

The separate individual decisions, and hence the overall aggregated outcome, will on average be swayed by the individual expectations[2] of this population, as well as specifically by individual needs and/or wants; and the latter can be assumed to be random in nature, cancelling out when aggregated[3].

In a number of fields, most notably in that of economics, frequent attempts have been made to model behaviour of key variables. Indeed, it has even been claimed that the individual economic agent must possess a formal model in order to generate his or her expectations [Hahn, 1973]. In view of the prevailing uncertainty, it is not surprising that many of these models, especially econometric attempts to model the macro-economy but even the less complex ones which are used in rational expectations work, have been doomed to ultimate failure. Even reference to elements of chaos theory, for example by Dopfer [1991], is unlikely to unlock the solution to this problem. In the context of expectations theory, this failure should primarily be seen as that of trying to accurately predict (mathematically) the dynamic outcomes of essentially non-rational processes, which are based on the aggregation of individual decisions, by the use of (typically static) rational models ,which are based upon discrete macro-variables.

The Aggregated Expectations Hypothesis would posit, however, that these models do still have an important, albeit different, role - as potentially powerful elements of the communication process. Some models, in this context, can offer a very potent means of influencing expectations; as is now recognised by those governments which use interest rates to communicate (signal) their own expectations of future changes in inflation. Paradoxically, one of the best examples was to be seen in the influence of the Chicago School of economists in general, and of Friedmann [1968] in particular; arising from their promotion of the simple model(s) behind monetarism. Their theories were eventually accepted by the majority of decision-makers; and built into their own expectations - in the terminology of our hypothesis - of future developments. Under those circumstances, monetarist theory was able to predict outcomes, for the relatively short time that these expectations were shared by the wider world, and enabled governments to influence those outcomes.

The nature of the model, as a communication device, becomes most apparent when we compare the success of this (monetarist) model with the equal success of that of the previous period - covering several decades - when the very different theories previously put forward by Keynes [1936] were just as well accepted. In their time, they as powerfully influenced expectations, with an even better track record in terms of predictability and of government use.

The change from Keynesianism to Monetarism also illustrated another feature applying to the hypothesis of aggregated expectations:

When there is a general shift in expectations from a basis in one model to that in another - paralleling Kuhn's[1970] paradigm shift - relative stability (in terms of predictability, at least) is replaced by a period of uncertainty; as the proportion of the population supporting the two competing models progressively shifts from one to the other (and the strength of their individual belief in the new model grows, as that of the old one wanes).

This may, thus, be seen as one contributor to the uncertainty which has been a characteristic of the macro-environment in recent decades. It has been compounded by the need for 'monetarists' to regularly modify their earlier, over-simplistic, theories to allow for discrepancies in the observed outcomes. The shifting nature of this recent (‘monetarist’) theory has possibly been one contributor to the on-going dissonance. In the context of stable, and predictable, expectations it is even arguable that it is better for a government to be consistently wrong - as in retrospect the Thatcher governments were - than to be inconsistently right - as John Major's governments have sometimes been subsequently.

This (expectations) communications aspect of modelling imposes rather different requirements. Previously, models were deemed most academically worthwhile - and supposedly more effectively productive - if they were reducible to exact mathematical equations. Indeed, they were sometimes thought to be even more worthwhile if such equations were so complex ('mirroring the complexity of nature') that only the most erudite elite could understand them.

In the new context, of communicating expectations, such mathematical complexity should be seen to work against many models - not least those developed by econometricians. Instead, in line with the parallel requirements in the commercial sector for 'conviction marketing'[Mercer, 1996], the key parameters for a persuasive model - one which most effectively influences expectations - are:

simplicity and clarity - the concepts have to be easily grasped by the population at large. The very simple message of monetarism, that of the devaluation caused by governments 'printing money', was easy to understand at a superficial level - even if it did not attempt to fully describe the complex issues involved.

distinctive, rich identity - the ideas have to be clearly differentiated from competitive offerings, as was monetarism, but ideally should also tap into a much richer 'value system', as was monetarism supported by the panoply of the (Chicago School) free-market debate.

believability, especially of the champions - the model must ultimately be believed by the majority of the population. This typically occurs because the promoter is believable, as was Friedmann on behalf of monetarism - where his 'opponent', Keynes, was dead.

strength of opponents - indeed, the comparison with the old paradigm, and especially with its supporters, is a key element in the battle for hearts and minds. The Keynesians were handicapped not just by the fact that their leader was no longer there to defend his theories, but - even worse - by the fact that they had foolishly also espoused the Phillips J Curve as a core element of their expanded theory (even though Keynes himself had written his theories, and died, before Phillips had propounded his). They were, therefore, highly vulnerable when Friedmann proved this particular theory to be false!

match to 'consumer' needs - finally, the concept(s) have to resonate with the population on which they are targeted. The main target of monetarism was the business community, and the economists who aspired to mediate between it and government, both of whom found the notion of the free-market emotionally, and practically, satisfying at a time when it was increasingly claimed that there was too much government intervention.

In addition, if such a model is to survive the ravages of time, it needs to incorporate:

ambiguity - such that it can be progressively reinterpreted to meet changing circumstances. This has happened to an extent with monetarist theory - and rational expectations itself can be viewed as one such reinterpretation. Most notably, though, it has also happened to the longest lived models of all; religious texts - such as the bible - which have been interpreted very differently by different sects at different times in history.

The Aggregated Expectations Hypothesis offers a new way of examining likely future outcomes, based upon observations of the most important contributor - expectations - to the individual decisions which aggregate to create the final macro-outcomes. It also offers the more powerful actors, especially governments, a new tool for influencing some of those future outcomes. One outcome is that (economic) models should be viewed primarily as communications devices. Their power depends upon how well they persuade the actors, on whom they are targeted, to bring their behaviour into line with that incorporated in the model.

Anderson, M.A and A. H. Goldsmith, (1994), “Rationality in the Mind’s Eye: An Alternative Test of Rational Expectations Using Subjective Forecast and Evaluation Data”, Journal of Economic Psychology, Vol. 15, pp.379-403

Dopfer, K, (1991), “The Complexity of Economic Phenomena”, Journal of Economic Issues, Vol. 25 (March)

Friedmann, M, (1968), “The Role of Monetary Policy”, American Economic Review

Keynes, John Maynard, (1936), The General Theory of Employment, Interest and Money

Kuhn, Thomas S, (1970), The Structure of Scientific Revolutions (2nd Edn), University of Chicago Press

Lucas, R.E, (1973), “Some International Evidence on Output-Inflation Trade-Off”, American Economic Review, Vol. 63, pp.326-334

Mercer, D, (1997), A General Hypothesis of Aggregated Expectations, Technological Forecasting and Social Change

Mercer, D, (1997), Determining Aggregated Expectations of Future Outcomes, Technological Forecasting and Social Change

Muth, J. F, (1961) “Rational Expectations and the Theory of Price Movements”, Econometrica, Vol. 29, pp. 315-335

Sargent, Thomas J, (1995), Bounded Rationality in Macroecomics, Oxford University Press

Shaw, G. K, (1987), “Rational Expectations”, Bulletin of Economic Research, Vol. 36 No. 3

Svensson, Lars E.O, (1996), “Scientific Contributions of Robert E. Lucas, Jr.”, Scandinavian Journal of Economics, Vol. 98 No. 1, pp.1-10

Wack, Pierre, (1985), “Scenarios: Uncharted Waters Ahead”, Harvard Business Review, Sep/Oct 1985: 139-150

Wack, Pierre, (1985), “Scenarios:Shooting the Rapids”, Harvard Business Review, Nov/Dec 1985: 139-150

[1] Made by the whole population involved, not just by the key economic actors involved - as in the rational expectations hypothesis.

[2] Usually observed by practical marketing research techniques, not predicted by theoretical models.

[3] This is similar to the forecast errors typically allowed for in rational expectations work, which are also essentially random with a mean value of zero [Shaw ,1987]. It is the reason this generalised theory is not applicable to individuals’ own circumstances.