The rationality of expectations formation

Davila Muro, Julio [UCL]

Rational expectations do not require beliefs to be consistent with history and with what agents can conclude from it. Actually, at a rational expectations equilibrium agents may hold beliefs that explain poorly the history they observe, even when restricted to only those rationalizing their choices. This paper shows that if agents hold rationally formed expectations instead —in the sense of following from beliefs that explain history better than any other beliefs justifying their choices— then additional allocations unsupported by rational expectations can be shown to be equilibrium outcomes. By means of this result, it is established too that adding common knowledge of the rationality of the formation of expectations —on top of that of rationality of choices and market clearing— does not suffice either to guarantee rational expectations. Interestingly, the rationally formed expectations equilibria produced in this paper exhibit a sunspot-like volatility that do not rely on an explicit sunspot mechanism.