316 JoHN F. MUTH ture of the system is changed. (This point is similar to the reason we are curious about demand functions, consumption functions, and the like instead of only the reduced form"predictors"in a simultaneous equatio system. )The area is important from a statistical standpoint as well, because parameter estimates are likely to be seriously biased towards zero if the wrong variable is used as the expectation The objective of this paper is to outline a theory of expectations and to show that the implications are-as a first approximation--consistent with the relevant data THE“ RATION AL EXPECTATIONS’ HYPOTHESIS Two major conclusions from studies of expectations data are the following 1. Averages of expectations in an industry are more accurate than naive models and as accurate as elaborate equation systems, although there are considerable cross-sectional differences of opinion 2. Reported expectations generally underestimate the extent of changes that actually take place In order to explain these phenomena, I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. At the risk of confusing this purely descriptive hypothesis with a pronounce- ment as to what firms ought to do, we call such expectations" rational. It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, especially changes over time(e.g, Simon [29]). Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality The hypothesis can be rephrased a little more precisely as follows that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory or the"objective probability distributions of outcomes The hypothesis asserts three things:(1)Information is scarce, and the conomic system generally does not waste it.(2) The way expectations are formed depends specifically on the structure of the relevant system describin the economy. (3)A public prediction, 'in the sense of Grunberg and modi gliani [14], will have no substantial effect on the operation of the economic system(unless it is based on inside information). This is not quite the same thing as stating that the marginal revenue product of economics is zero 3 We show in Section 5 that the hypothesis is consistent with these two phenomena316 JOHN F. MUTH ture of the system is changed. (This point is similar to the reason we are curious about demand functions, consumption functions, and the like, instead of only the reduced form "predictors" in a simultaneous equation system.) The area is important from a statistical standpoint as well, because parameter estimates are likely to be seriously biased towards zero if the wrong variable is used as the expectation. The objective of this paper is to outline a theory of expectations and to show that the implications are-as a first approximation-consistent with the relevant data. 2. THE "RATIONAL EXPECTATIONS" HYPOTHESIS Two major conclusions from studies of expectations data are the following: 1. Averages of expectations in an industry are more accurate than naive models and as accurate as elaborate equation systems, although there are considerable cross-sectional differences of opinion. 2. Reported expectations generally underestimate the extent of changes that actually take place. In order to explain these phenomena, I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.3 At the risk of confusing this purely descriptive hypothesis with a pronounce￾ment as to what firms ought to do, we call such expectations "rational." It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, especially changes over time (e.g., Simon [29]). Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality. The hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the "objective" probability distributions of outcomes). The hypothesis asserts three things: (1) Information is scarce, and the economic system generally does not waste it. (2) The way expectations are formed depends specifically on the structure of the relevant system describing the economy. (3) A "public prediction," in the sense of Grunberg and Modi￾gliani [14], will have no substantial effect on the operation of the economic system (unless it is based on inside information). This is not quite the same thing as stating that the marginal revenue product of economics is zero, 3 We show in Section 5 that the hypothesis is consistent with these two phenomena