<h2>CHAPTER 1</h2><p><i>Rational Expectations and theReconstruction of Macroeconomics</i></p><p>The government has strategies. The people havecounterstrategies.</p><p>Ancient Chinese proverb</p><br><p><i>Behavior Changes with the Rules of the Game</i></p><p>In order to provide quantitative advice about the effects of alternativeeconomic policies, economists have constructed collections ofequations known as <i>econometric models</i>. For the most part thesemodels consist of equations that attempt to describe the behavior ofeconomic agents—firms, consumers, and governments—in termsof variables that are assumed to be closely related to their situations.Such equations are often called <i>decision rules</i> because theydescribe the decisions people make about things like consumptionrates, investment rates, and portfolios as functions of variables thatsummarize the information people use to make those decisions.For all of their mathematical sophistication, econometric modelsamount to statistical devices for organizing and detecting patternsin the past behavior of people's decision making, patterns that canthen be used as a basis for predicting their future behavior.</p><p>As devices for extrapolating future behavior from the past undera given set of rules of the game, or government policies, thesemodels appear to have performed well. They have not performedwell, however, when the rules changed. In formulating advice forpolicymakers, economists have routinely used these models to predictthe consequences of historically unprecedented, hypotheticalgovernment interventions that can only be described as changesin the rules of the game. In effect, the models have been manipulatedin a way that amounts to assuming that people's patterns ofbehavior do not depend on those properties of the environmentthat government interventions would change. The assumption hasbeen that people will act under the new rules just as they haveunder the old, so that even under new rules, past behavior is stilla reliable guide to future behavior. Econometric models used inthis way have not been able to predict accurately the consequencesof historically unparalleled interventions. To take one recent example,standard Keynesian and monetarist econometric modelsbuilt in the last 1960s failed to predict the effects on output, employment,and prices that were associated with the unprecedentedlarge deficits and rates of money creation of the 1970s.</p><p>Recent research has been directed at building econometric modelsthat take into account that people's behavior patterns will varysystematically with changes in government policies—the rules ofthe game. Most of this research has been conducted by adherentsof the so-called hypothesis of rational expectations. They modelpeople as making decisions in dynamic settings in the face of well-definedconstraints. Included among these constraints are lawsof motion over time that describe such things as the taxes peoplemust pay and the prices of the goods they buy and sell. The hypothesisof rational expectations is that people understand theselaws of motion. The aim of the research is to build models thatcan predict how people's behavior will change when they are confrontedwith well-understood changes in ways of administeringtaxes, government purchases, aspects of monetary policy, and thelike.</p><br><p>The Investment Decision</p><p>A simple example will illustrate both the principle that decisionrules depend on the laws of motion that agents face and the extentthat standard macroeconomics models have violated this principle.Let <i>k<sub>t</sub></i> be the capital stock of an industry and τ<sub><i>t</i></sub> be a tax rate on capital.Let τ<sub><i>t</i></sub> be the first element of <i>z<sub>t</sub></i>, a vector of current and laggedvariables, including those that the government considers whenit sets the tax rate on capital. We have τ<sub><i>t</i></sub> [equivalent to] <i>e<sup>T</sup>z<sub>t</sub></i>, where <i>e</i> is theunit vector with unity in the first place and zeros elsewhere. Let afirm's optimal accumulation plan require that capital acquisitionsobey</p><p>[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1.1)</p><p>where <i>E<sub>t</sub>τ<sub>t+j</sub></i> is the tax rate at time <i>t</i> that is expected to prevail attime <i>t + j</i>.</p><p>Equation 1.1 captures the notion that the demand for capitalresponds negatively to current and future tax rates....