Change and Expectations in Macroeconomic Models: Recognizing the Limits to Knowability | E-Axes

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Change and Expectations in Macroeconomic Models: Recognizing the Limits to Knowability


In the first part of this paper, we sketch how this core premise (that fully predetermined accounts of change are possible) has derailed the development of macroeconomic analysis for the last four decades.2 We discuss why portraying outcomes with fully predetermined models lacks any connection – even as a bold abstraction – to how individuals forecast outcomes in real-world markets. Moreover, we explain how ignoring the limits to knowability has underpinned economists’ widespread belief that the so-called Rational Expectations Hypothesis (REH) represents how rational individuals forecast the future. That belief, we point out, has obscured our understanding of markets’ role in modern economies, and of how, in many markets, their participants’ forecasting drives outcomes. It has also led to a false dichotomy: rational decision-making based on fundamental considerations versus irrational behavior driven by psychological factors.

In the second part of the paper, we discuss how Imperfect Knowledge Economics (IKE) jettisons extant models’ core premise, and how this helps us to overcome their epistemological flaws. By opening economic models to non-routine change and recognizing imperfect knowledge on the part of economists, IKE reflects the fact that, as Popper put it, “Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objectively open” (Popper, 1990, p. 18, emphasis added).

To download the PDF version of the working paper click here.

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