Rationality, specification tests, and macroeconomic models

Rational expectation models embody cross-equation restrictions that are implied by the theory of rational expectations. In this paper we illustrate how tests of these restrictions may be implemented in terms of general macroeconomic models by employing the models of Taylor and Sargent as examples. In addition, the more important issue of the proper interpretation of the results of these tests is addressed. We contend that tests for rationality should become part of the model-building process as they are akin to specification tests for models in which rational expectations is treated as the maintained hypothesis. A procedure is suggested when the restriction are inconsistent with data. Special emphasis is placed upon examining how changes in specifications of the model's exogenous variables can influence test results.