Paying attention to inattention

by Olivier Coibion and Yuriy Gorodnichenko

Vox
August 24, 2012

Economics and economists have taken a beating in the last few years. One practice on the receiving end of much criticism has been the use of models that assume rational expectations when individuals are well informed. This column proposes some tests of these assumptions and argues that 'imperfect information' models may succeed where others have failed.

It should be clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations ...

Paul Volcker, 27 October 2011

Macroeconomics has taken a public flogging since the onset of the financial crisis, both from those outside the profession (such as the Oscar-winning documentary Inside Job) as well as from some insiders (such as Krugman’s Dark Age of Macroeconomics). One prevalent criticism is the assumption of full-information rational expectations (FIRE) under which economic agents know the structure and parameters of the economic model, observe all shocks and variables in real time, and form identical expectations. And while the FIRE assumption is indeed common in macroeconomic models, macroeconomists have long been exploring departures from full information. Lucas (1972) and Kydland and Prescott (1982) are early examples of models in which agents face imperfect information, and both Tom Sargent and Chris Sims – the two most recent Nobel recipients in economics – have done groundbreaking work along these lines.

Attention to models of inattention has been particularly high over the last decade since the pioneering work of Mankiw and Reis (2002), Sims (2003) and Woodford (2001). Each propose models that embed face information rigidities – frictions which lead rational agents to have only imperfect information about economic conditions – thereby departing from the full-information component of FIRE. The recent survey of this literature by Mankiw and Reis (2011) documents that models of imperfect information can address a number of puzzles in macroeconomics, international economics and finance.

At the same time, empirical evidence on the nature of the expectations formation process has been limited. While there is a long literature testing the FIRE assumption, it has proven difficult to quantify the economic significance (for example, does a departure make a difference for the macroeconomy?) and to interpret the nature of the rejections (for example, is it irrationality or imperfect information?). In recent work (Coibion and Gorodnichenko 2011, 2012), we propose and apply new empirical tests – derived directly from theoretical models of imperfect information – that shed new light on the expectations formation process of economic agents by addressing both limitations of traditional tests.

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