The need for a new paradigm.

Since the start of the rational-expectations revolution in the mid 1970s, macroeco­ nomic analysis has been dominated by the assumption of the rational representative agent. This assumption has now become the main building block of macroeconomic modeling, so much so that macroeconomic models without a microfoundation based on the rationality assumption are simply no longer taken seriously. The main ingredients of the rational representative agent model are well-known. First, the representative agent is assumed to continuously maximize his utility in an intertemporal framework. Second, the forecasts made by this agent are rational in the sense that they take all available information into account, including the infor­ mation embedded in the structure of the model. This implies that agents do not make systematic errors in forecasting future variables. The great attractiveness of the rational-expectations model is that it imposes consistency between the agent’s forecasts (the subjective probability distribution of future variables) and the fore­ casts generated by the model (the objective probability). Third, the model implies that markets are efficient, i.e., asset prices (including the exchange rate that will be the focus of our analysis in this book) reflect all relevant information about the fundamental variables that determine the value of the asset. The mechanism that ensures efficiency can be described as follows: when rational agents value a partic­ ular asset, they compute the fundamental value of that asset and price it accordingly. If they obtain new information, they will immediately incorporate that information in their valuation of the asset. Failure to arbitrage on that new information would imply that they leave profit opportunities unexploited. Rational agents will not do this.1 The efficient-market implication of the model is important because it generates a number of predictions that can be tested empirically. The main empirical prediction of the rational representative agent model is that changes in the price of an asset must reflect unexpected changes (news) of the fundamental variables. The corollary of