Imperfect Knowledge Economics embodies Karl Popper’s key insight about our predictive capacity: “Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objectively open.” Since the early 1970s, macroeconomists and finance theorists have presumed the opposite. They have come to rely on internally consistent models that fully specify in advance how market participants might alter the ways in which they make decisions and how aggregate outcomes unfold over time. These so-called “rational expectations” (RE) models have encountered widespread empirical difficulties in explaining outcomes, most notably in financial markets. Macroeconomists and finance theorists have proposed a variety of explanations for these shortcomings, including irrationality and psychological biases on the part of market participants.
The Institute’s Program on Imperfect Knowledge Economics has developed a different explanation of RE models’ empirical difficulties: they do not represent rational decision-making in real-world markets, where no one can fully foresee how the economy’s structure will change. We show that opening macroeconomics and finance models to unanticipated structural change does not spell the end of formal economic theory that can serve as the basis for representing rationality and that can be confronted with time-series data. On the contrary, recognizing the inherent limits to what economists and market participants can know about change appears to be crucial for understanding market outcomes and the consequences of alternative economic policies.