The thesis of this essay is that, in heterogeneous agent macroeconomics, the assumption of rational expectations about equilibrium prices is unrealistic, unnecessarily complicates computations, and should be replaced. This is because rational expectations imply that decision makers forecast equilibrium prices like interest rates by forecasting cross-sectional distributions. The result is an extreme version of the curse of dimensionality: dynamic programming problems in which the entire cross-sectional distribution is a state variable (“Master equation” a.k.a. “Monster equation”). This is not only unrealistic but also limits the applicability of the heterogeneous-agent approach to some of the biggest questions in macroeconomics, namely those in which aggregate risk and non-linearities are key, like financial crises. This troublesome feature of the rational expectations assumption poses a challenge: what should replace it? I outline three criteria that alternative approaches should satisfy: (1) simplification of the computational solution, (2) consistency with empirical evidence, and (3) (some) immunity to the Lucas critique. I then discuss some potentially promising directions, including temporary equilibrium approaches, incorporating survey expectations, least-squares learning, and reinforcement learning.
About the speaker:
Benjamin Moll is the Sir John Hicks Professor of Economics at the London School of Economics. He is a macroeconomist studying how the enormous heterogeneity observed at the micro level, and in particular the large disparities in income and wealth, impact the macro economy and macroeconomic policy. Moll’s work analyzes the macroeconomic and distributional consequences of monetary and fiscal policy as well as disruptions like the Covid-19 pandemic or the European energy crisis. He holds a Ph.D. from the University of Chicago. Moll is a Fellow of the Econometric Society, the recipient of the Bernácer Prize for best European economist under 40 working in macroeconomics and finance, the Calvó-Armengol International Prize in Economics, and a coeditor of the American Economic Review.
