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November 14, 2005
Testing rational expectations
One of the more interesting consequences of the economic theory of rational expectations is that individuals save their windfalls (lottery, inheritances, tax refunds) and spend their raises, cost of living adjustments, and other permanent increases in income. This follows from an arguments about smoothing changes in consumption. Since people prefer to have a stable amount of consumption to famine mixed with plenty, they save temporary income to supplement the uncertain future.
Human beings, sometimes straying from this hyper-rational abstraction, spend their windfalls until they collapse back into the poverty from which they emerged. There are a few justifications offered for this in economics, that they discount highly their future happiness, that consumers don't actually believe that such income is temporary, or that smoothing just isn't important to them, perhaps because their is no diminishing marginal utility of income. But that isn't to say that the theory belongs in economics's dustbin.
Comparative economics has the potential to remove the distractions of human behavior. Take for example the small orange tree that sits in my living room. How could we test if rational expectations held for this plant? Let's say that you replanted it in a spacious lawn in southern Florida. Drenched with sun and water, this would represent a permanent income change for the tree. As such you'd see an expansion in the consumption of the tree, which is making oranges to create more orange trees. On the other hand, let's say there were a rash of sunny days in August, but that were quickly followed by a cold September. The plant, sensing that it has merely received a solar windfall, invests in deeper roots, nutrient storage, and growing more leaves. In effect, it saves. Now we have some testable hypotheses beyond humans. Create a situation where plants or animals are broken into three categories, a control, those subject to a windfall and those to an income effect. Then simply check for changes in savings (usually food storage or sharing behavior) and consumption (usually reproduction) behavior.
Posted by OneEyedMan at November 14, 2005 10:02 AM
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