Evans and Honkapohja: What do you mean?
Sargent: Originally, we defined a rational expectations equilibrium in
terms of the ‘communism of models’ that I alluded to earlier. By ‘model’, I mean
a probability distribution over all of the inputs and outcomes of the economic
model at hand. Within such a rational expectations equilibrium, agents can have
different information, but they share the same model. Learning theories in both
macroeconomics and game theory have discovered that the natural limit points
of a variety of least-squares learning schemes are what Kreps, Fudenberg, and
Levine call ‘self-confirming equilibria’. In a self-confirming equilibrium, agents
can have different models of the economy, but they must agree about events that
occur sufficiently often within the equilibrium. That restriction leaves agents
free to disagree about off-equilibrium outcomes. The reason is that a law of large
numbers doesn’t have enough chances to act on such infrequent events. In the
types of competitive settings that we often use in macroeconomics, disagreement
about off-equilibrium-path outcomes among small private agents don’t matter.
Those private agents need only to predict distributions of outcomes along an
equilibrium path. But the government is a large player. If it has the wrong
model about off-equilibrium-path outcomes, it can make wrong policy choices,
simply because it is wrong about the counterfactual thought experiments that go
into solving a Ramsey problem, for example. No amount of empirical evidence
drawn from within a self-confirming equilibrium can convince a government
that it is wrong about its model, because its model is correct for all frequently
observed events. To be motivated to change its model, the government must
either experiment or listen to a new theorist. The theorist has to come up
with a model that is observationally equivalent with the government’s model
for the old self confirming equilibrium outcomes, but that improves the analysis
of counterfactuals relative to those outcomes.
Evans and Honkapohja: Are there interesting examples of this kind of
thing occurring in the macroeconomy?
Sargent: You can tell a story that this is what Lucas was up to with
his 1972 JET paper on the natural rate. If you alter Kydland and Prescott’s
1977 version of Lucas’s story a little, you can alter their timing protocol and
reinterpret Kydland and Prescott’s sub optimal time consistent equilibrium as
a self-confirming equilibrium that could be improved with a better government
model of off equilibrium path outcomes.
Evans and Honkapohja: Wasn’t this part of your story in The Conquest
of American Inflation ?
Sargent: Yes.
Evans and Honkapohja: So it seems that you can talk about disagree-
ments among models within a rational expectations framework if you extend
the concept of rational expectations to mean ‘self-confirming’.
Sargent: Yes. This is a nice feature of self-confirming equilibrium mod-
els. My reading of disputes about economic policy is that they are not merely