A New Theory of Expectations

Expectations are essential for understanding the economic choices of individuals as well as cyclical developments in an economy over time. The initial theory of how people form their expectations was first introduced by Aristotle more than two millennia ago. The core elements he advanced were that forward-looking decisions must be based on expectations and those expectations must be formed by reason, free from the corrupting influence of passion. These guidelines have been formalized in theories of rational expectations. There has been no consensus among social scientists, however, about whether rationality should be defined by how expectations are formed (favored in psychology) or by the outcomes of the formation process (favored in economics). Data collected by the University of Michigan over the past half-century appear to support both views: the psychological thesis of bounded rationality in the formation of expectations by individuals as well as the unbounded rationality thesis of economics when applied to the expectations observed across the entire economy. The goal of this paper is to correct empirical misspecifications, and to incorporate recent advances in neuroscience, including the dominance of nonconscious processes over conscious deliberation, the critical role of affective evaluations, and the formation of expectations by a Bayesian updating procedure. The new theory highlights the importance of contextual factors, and provides a more accurate assessment of costs and benefits. Although these innovations represent a radical departure from orthodox theories, they are justified by the increase in explanatory power provided by this new theory of expectations.