Testing for the Strong Form of Rational Expectations with Heterogeneously Informed Agents

Abstract

In recent years, political scientists have tested for the existence of rational expectations (RE) using survey-based aggregate data on subjective economic perceptions. These tests suffer from several conceptual shortcomings of a nontrivial nature. In this study, the meaning of RE is clarified, and also a test for strong rational expectations (SRE) where citizens possess heterogeneous information levels is set forth. These empirical tests provide insights into what kinds of information citizens use in forming expectations from that which they do not utilize but could employ to arrive at more accurate forecasts. Using inflation expectations data for the period January 1978—December 1993, the empirical findings indicate that citizens can benefit from greater reliance on objective economic and political conditions when formulating their inflation expectations. The broader implications of this work pertain not only to the execution of RE tests in political science, but also to distinguishing which types of information people do and do not (but could) incorporate in their decision-making calculus.

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