Wanting Robustness in Macroeconomics

1.1. Foundations. von Neumann and Morgenstern (1944), Savage (1954), and Muth (1961) created mathematical foundations that applied economists have used to construct quantitative dynamic models for policy making. These foundations give modern dynamic models an internal coherence that lead to sharp empirical predictions. When we acknowledge that models are approximations, logical problems emerge that unsettle those foundations. Because the rational expectations assumption works the presumption of a correct specification particularly hard, admitting model misspecification raises especially interesting problems about how to extend rational expectations models. Because empirical models must be tractable, meaning that it is practical to solve, estimate, and simulate them. Misspecification comes with the simplifications that facilitate tractability, so model misspecification is unavoidable in applied economic research. Applied dynamic economists readily accept that their models are approximations. A model is a probability distribution over a sequence. The rational expectations hypothesis delivers empirical power by imposing a communism of models: the people being modeled, the econometrician, and nature share the same model, i.e., the same probability distribution over sequences of outcomes. This ‘communism’ is used both in solving a rational expectations model and when a law of large numbers is appealed to when justifying GMM or maximum likelihood estimation of model parameters. Imposition of a common model removes economic agents’ models as objects that require separate specification. The rational expectations hypothesis converts agents’ beliefs from model inputs to model outputs.