The Institute Blog

Rethinking Expectations: The Way Forward for Macroeconomics

INET is pleased to announce that Roman Frydman, Chair of INET’s Program on Imperfect Knowledge Economics, has published a book with Edmund Phelps, 2006 Nobel laureate and Director of the Center on Capitalism and Society at Columbia University, Rethinking Expectations: The Way Forward for Macroeconomics (Princeton University Press).

The book includes an introductory essay by Frydman and Phelps, a chapter by Phelps, and two chapters by Frydman and Senior Research Associate of INET’s Program on IKE, Michael Goldberg. Other contributions include chapters by Philippe Aghion, Sheila Dow, George W. Evans, Roger E. A. Farmer, Roger Guesnerie, Seppo Honkapohja, Katarina Juselius, Enisse Kharroubi, Blake LeBaron, John B. Taylor, Michael Woodford, and Gylfi Zoega.

The book originated from a 2010 conference at Columbia's Center on Capitalism and Society marking the fortieth anniversary of the publication of the landmark volume edited by Phelps, Microeconomic Foundations of Employment and Inflation Theory. Phelps’s book is often credited with pioneering the currently dominant approach to macroeconomic analysis. However, in their introductory essay in Rethinking Expectations, Frydman and Phelps argue that the vast majority of macroeconomic and finance models developed over the last four decades derailed, rather than built on, the Phelps volume's “micro-foundations” approach. Whereas contributors to the 1970 volume recognized the fundamental importance of according market participants' expectations an autonomous role, contemporary models rely on the rational expectations hypothesis (REH), which rules out such a role by design.

The alternatives proposed in Rethinking Expectations differ in important respects from the approach promoted in the Phelps volume. But the recent flurry of theoretical efforts has been notable for returning in one way or another to non-REH modeling of market participants’ expectations and their active role in driving aggregate outcomes. The new models have led to reconsideration of some of the main problems that occupied the contributors to the Phelps volume and subsequent REH researchers as well: explaining unemployment fluctuations, modeling the natural rate of unemployment, and investigating the unemployment-inflation tradeoff.

In view of the financial crisis, recent research efforts have also been focused on closely related themes like understanding the role of expectations in modeling movements in asset prices and risk, and representing the two-way interdependence between asset markets and the real economy. The crisis also has demanded reconsideration of the theory and practice of economic policy, specifically, the balance between rules and discretion in a world of non-routine change. Rethinking Expectations will help fill the current void in economic thinking and address these important challenges.

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