Quantitative Economics: Jul, 2021, Volume 12, Issue 3

Rationalizing rational expectations: Characterizations and tests

Xavier D'Haultfoeuille, Christophe Gaillac, Arnaud Maurel

In this paper, we build a new test of rational expectations based on the marginal distributions of realizations and subjective beliefs. This test is widely applicable, including in the common situation where realizations and beliefs are observed in two different data sets that cannot be matched. We show that whether one can rationalize rational expectations is equivalent to the distribution of realizations being a mean‐preserving spread of the distribution of beliefs. The null hypothesis can then be rewritten as a system of many moment inequality and equality constraints, for which tests have been recently developed in the literature. The test is robust to measurement errors under some restrictions and can be extended to account for aggregate shocks. Finally, we apply our methodology to test for rational expectations about future earnings. While individuals tend to be right on average about their future earnings, our test strongly rejects rational expectations.

Rational expectations test subjective expectations data combination C12 D84 E24

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