Rational Expectations: A Nobel Prize Winner Discovered a Way to Put Actual Human Beings Back Into Economic Theory
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All scholars strive to make important contributions to their discipline. Thomas J. Sargent irrevocably transformed his.
In the early 1970s, inspired by the groundbreaking work of Robert Lucas, Sargent and colleagues at the University of Minnesota rebuilt macroeconomic theory from its basic assumptions and micro-level foundations to its broadest predictions and policy prescriptions.
This “rational expectations revolution,” as it was later termed, fundamentally changed the theory and practice of macroeconomics. Prior models had assumed that people respond passively to changes in fiscal and monetary policy; in rational-expectations models, people behave strategically, not robotically. The new theory recognized that people look to the future, anticipate how governments and markets will act, and then behave accordingly in ways they believe will improve their lives.
Therefore, the theory showed, policy makers can’t manipulate the economy by systematically “tricking” people with policy surprises. Central banks, for example, can’t permanently lower unemployment by easing monetary policy, as Sargent demonstrated with Neil Wallace, because people will (rationally) anticipate higher future inflation and will (strategically) insist on higher wages for their labor and higher interest rates for their capital.
“The more dynamic, uncertain, and ambiguous is the economic environment that you seek to model, the more you are going to have to roll up your sleeves, and learn and use some math. That’s life.”
This perspective of a dynamic, random macroeconomy demanded deeper analysis and more sophisticated mathematics. Sargent pioneered the development and application of new techniques, creating precise econometric methods to test and refine rational expectations theory.
But by no means has Sargent limited himself to rational expectations. Among his dozen books and profusion of research articles are key contributions to learning theory (the study of the foundations and limits of rationality) and economic history, including influential work on monetary standards and international episodes of inflation.
Sargent, a Hoover senior fellow, was awarded the Nobel Prize in economics in 2011, along with Christopher Sims, a professor at Princeton University. Here are excerpts of an interview conducted before they were awarded their shared Nobel.