Discussion Paper

No. 2012-27 | June 07, 2012
On the Power and Weakness of Rational Expectations: Logical Fallacies, Periodic Bubbles and Business Cycles


A popular interpretation of the Rational Expectations/Efficient Markets hypothesis states that, if the hypothesis holds, then market valuations must follow a random walk. This postulate has frequently been criticized on the basis of empirical evidence. Yet the assertion itself incurs what we could call 'fallacy of probability diffusion symmetry': although market efficiency does indeed imply that the mean (i.e. 'expected') path must be a random walk, if the probability diffusion process is asymmetric then the observed path will most closely resemble not the mean but the median, which does not necessarily follow a random walk.
To illustrate the implications, this paper develops an efficient markets model where the median path of Tobin’s q ratio displays regular cycles of bubbles and crashes reflecting an agency problem between investors and producers. The model is tested against U.S. market data, with results suggesting that such a regular cycle does indeed exist and is statistically significant. The aggregate production function in Gracia (Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function, 2011) is then put forward to show how financial fluctuations can drive the business cycle by periodically impacting aggregate productivity and, as a consequence, GDP growth.

JEL Classification:

G14, G12, E32, E22, E23


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Cite As

Eduard Gracia (2012). On the Power and Weakness of Rational Expectations: Logical Fallacies, Periodic Bubbles and Business Cycles. Economics Discussion Papers, No 2012-27, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2012-27

Comments and Questions

Philip George - Financial bubbles and money
June 08, 2012 - 04:07

That financial bubbles affect the real economy through the agency of the banking system is well known. In the Great Depression, Japan's Lost Decade and the Great Recession, the pattern was similar: a collapse in the prices of one or more financial assets followed by the collapse or near-collapse of ...[more]

... a substantial number of banks followed by a collapse of the real economy. So I find it a little surprising that the paper makes no mention of banks at all.

I have developed a measure of money (called Corrected Money Supply). It is calculated by taking M1, adding sweeps, and subtracting savings. The logic is that savings are not spent and therefore do not constitute a medium of exchange. This measure agrees exactly with market movements and real economy movements since 1960. The starting year is 1960 because savings data are only available from 1959.

The calculations and the theoretical rationale are explained in detail in my book "The General Theory of Money" which is available on Kindle at http://www.amazon.com/dp/B0080WPK2I

Incidentally it predicts that we are heading for a crash of epic proportions, probably to be followed by a Depression.

Eduard Gracia - Financial bubbles and money
June 08, 2012 - 13:39

Thank you for your comments. The model in this paper was designed to model market bubbles and crashes in as parsimonious a way as possible; hence, banks and money were not left out because they would be irrelevant (which they are not) but because they represented a hypothesis this particular ...[more]

... model could do without. It is, however, mentioned in the conclusions that the same device (namely, the assumption of an asymmetric stochastic diffusion process) could be the basis for a model of non-neutral money, for the efficient market hypothesis can in principle guarantee money neutrality only along the mean (i.e. expected) path, whereas the observed time series would be closer to the median – which, in an asymmetric diffusion process, can be very different from the mean.

Anonymous - Referee Report 1
July 11, 2012 - 10:48

see attached file

Eduard Gracia - Comments to Referee 1 Report
July 15, 2012 - 11:14

Above all, I would like to express my appreciation for this referee's very thorough, helpful comments. I essentially agree with all the suggestions put forward in the report, and I will try to address them in a revised version of the paper.

Attached is nevertheless a longer reply document ...[more]

... with a few clarification points that I feel may be of interest related to some of the referee's general comments.