The Trouble with Rational Expectations in Heterogeneous Agent Models: A Challenge for Macroeconomics
2025-11-13
The thesis of this essay is that, in heterogeneous agent macroeconomics, the assumption of rational expectations about equilibrium prices is unrealistic and should be replaced. Rational expectations imply that decision-makers forecast equilibrium prices like interest rates by forecasting cross-sectional distributions. This leads to an extreme version of the curse of dimensionality: dynamic programming problems in which the entire distribution is a state variable (the ‘Master equation’, also known as the ‘Monster equation’). Frontier computational methods struggle with these infinite-dimensional Bellman equations, making it implausible that real-world agents solve the associated decision problems. These difficulties also limit the applicability of the heterogeneous agent approach to central questions in macroeconomics—those involving aggregate risk and non-linearities such as financial crises. This troublesome feature of the rational expectations assumption poses a challenge: what should replace it? I outline three criteria for alternative approaches: (1) computational tractability, (2) consistency with empirical evidence and (3) (some) immunity to the Lucas critique. I then discuss several promising directions, including temporary equilibrium approaches, incorporating survey expectations, least-squares learning and reinforcement learning.