Evans and Honkapohja: When did you first use rational expectations
to restrict a distributed lag or a vector autoregression in empirical work?
Sargent: In a 1971 paper on testing the natural unemployment rate
hypothesis. I figured out the pertinent cross-equation restrictions and showed
that in general they didn’t imply the ‘sum-of-the-weights’ test on distributed
lags that was being used to test the natural rate hypothesis. That was easy
because for that problem I could assume that inflation was exogenous and use
a univariate process for inflation. My 1973 and 1977 papers on rational ex-
pectations and hyperinflation tackled a more difficult problem. Those papers
found the cross-equation restrictions on a VAR for money and prices by reverse
engineering a joint process for which Cagan’s adaptive expectations formula de-
livers optimal forecasts. This was worth doing because Cagan’s model fit the
data so well. Imposing rational expectations exposed a lot about the Granger
causality structure between money and prices that prevailed during most of the
hyperinflations that Cagan had studied.
Evans and Honkapohja: Econometrically, what was the big deal about
rational expectations?
Sargent: Cross-equation restrictions and the disappearance of any free
parameters associated with expectations.
Evans and Honkapohja: What do you mean ‘disappearance’ ?
Sargent: In rational expectations models, people’s beliefs are among the
outcomes of our theorizing. They are not inputs.
Evans and Honkapohja: Do you think that differences among people’s
models are important aspects of macroeconomic policy debates?
Sargent: The fact is that you simply cannot talk about those differences
within the typical rational expectations model. There is a communism of mod-
els. All agents inside the model, the econometrician, and God share the same
model. The powerful and useful empirical implications of rational expectations
— the cross-equation restrictions and the legitimacy of the appeal to a law of
large number in GMM estimation — derive from that communism of models.
Evans and Honkapohja: What role do cross-equation restrictions play
in Lucas’s Critique?
Sargent: They are everything. The positive part of Lucas’s critique
was to urge applied macroeconomists and econometricians to develop ways to
implement those cross equation restrictions. His paper had three examples.
What transcends them is their cross-equation restrictions, and the absence of
free parameters describing expectations. In a nutshell, Lucas’s critique of pre-
rational expectations work was, “you have ignored cross equation restrictions,
and they are all important for policy evaluation.”
Evans and Honkapohja: What do those cross-equation restrictions have
to say about the evidence in favor of coefficient volatility that Bob Lucas talked
about in the first part of his ‘Critique’ ?