Bounded Rationality in Macroeconomics.

• Author: Vaughan, Mark D.

When former communists denounce Lenin, it makes headlines. A public disavowal of rational expectations by Thomas Sargent would also make headlines. In his new book, Bounded Rationality in Macroeconomics, Sargent does not quite apostatize. Yet, he does concede that rational expectations modeling leaves important research and policy questions unanswered. To search for potential answers, Sargent surveys the literature on bounded rationality. He also advocates bounded rationality as a new approach to macroeconomic modeling. Though Sargent offers an effective literature survey and several interesting applications of bounded rationality, he fails to persuade the general reader to embrace the new approach. Indeed, Sargent's reliance on mathematics at the expense of intuition limits the audience of Bounded Rationality in Macroeconomics to economists with highly technical research tastes.

Sargent's literature survey is effective because it clearly contrasts modeling with bounded rationality and modeling with rational expectations. In a rational expectations model, agents optimize subject to constraints and hold mutually consistent views about the constraints. Mutual consistency of views implies that agents know a great deal about the environment. As Sargent puts it:

When implemented numerically or econometrically, rational expectations models impute much more knowledge to the agents within the model (who use the equilibrium probability distributions in evaluating their Euler equations) than is possessed by an econometrician, who faces estimation and inference problems that the agents in the model have somehow solved [p. 3].

In contrast, bounded rationality drops the assumption of mutually consistent perceptions. Dropping mutual consistency forces agents to act like econometricians; now agents in the model must use theory and statistics to learn about the environment. While more realistic as a working assumption than rational expectations, bounded rationality exacts a computational price. Again, in Sargent's words:

Ironically, when we economists make the people in our models more "bounded" in their rationality and more diverse in their understanding of the environment, we must be smarter, because our models become larger and more demanding mathematically and econometrically [p. 2].

Researchers will pay the computational price if bounded rationality promises a large return. Sargent sees large returns in three areas of research: multiple equilibria...