Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State

By Roman Frydman; Michael D. Goldberg | Go to book overview

4
The Figment of the “Rational Market”

IN PROPOSING the Rational Expectations Hypothesis, Muth did not think of it as a normative hypothesis that individuals were omniscient or that they all thought alike. He also did not claim that the hypothesis presumes that every market participant must forecast according to the relevant economic theory: the Rational Expectations Hypothesis “does not assert that the scratch work of entrepreneurs resembles the system of equations [in an economist’s model] in any way” (Muth, 1961, p. 317). Moreover, it does not imply “that predictions of [individuals] are perfect or that their expectations are all the same” (Muth, 1961, p. 317).

However, Muth held out the promise that one day economists would formulate a fully predetermined model that would adequately portray how the market—its participants in the aggregate—forecasts the future. Indeed, he viewed the Rational Expectations Hypothesis as if an economist’s fully predetermined model could provide an adequate portrayal of both the market’s forecasting strategy and the process driving market outcomes. The Rational Expectations Hypothesis supposes that both are “essentially the same”:1

1By “essentially the same,” Muth meant that, when an economist imposes the Rational Expectations Hypothesis in his fully predetermined model, he hypothesizes that the causal factors and weights that he selects adequately capture a combination of market participants’ forecasting strategies—each with potentially different causal factors and different weights attached to them.

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