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Errors in rational expectations matter.

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PII: 0165-1765(93)90106-M Economics Letters 41 (1993) 25-28 01651765/93/$06.00 0 1993 Elsevier Science Publishers B.V. All rights reserved 25 Errors in rational expectations matter Lex Borghans Research Centre for Education and the Labour Market, PO Box 616, NL-6200 MD Maastricht, Netherlands Received 23 July 1992 Accepted 1 September 1992 Abstract Muth (Econometrica, 1961, 29, 299-306) and Sargent and Wallace (Journal of Monetary Economics, 1976, 2, 169-183) claimed that the main results of rational expectations theory allow for possibly large independent errors. This paper shows that in such a situation the pseudo rational expectation is no longer optimal. I. Introduction Uncertainty plays an important role in educational choice. This choice determines the future occupational possibilities, and since many courses take several years, students have to form expectations about the complex and non-transparent labour market. The uncertainty students face has been studied both by cobweb models [Freeman (1971)] and by rational expectations models [Siow (1984) and Zarkin (1985)]. The problem with the cobweb model is that it imposes an expectation behaviour which is a priori non-optimal. On the other hand, rational expectations theory assumes that all prediction errors are due to uncertainty about the future state of the world, and therefore implicitly assumes that students do not make errors in the forecasts themselves. They are assumed to have perfect insight in the functioning of the labour market. Muth (1961), and Sargent and Wallace (1976) claim, however, that the main results of the rational expectations theory are not influenced by the introduction of an independent random error term. In this paper this proposition is challenged by showing that in the case of such random errors this pseudo rational expectation is no longer optimal. 2. Information versus interpretation errors Suppose students have to forecast the wage they will earn after some kind of

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