FREDERIC S. MISHKIN Universityof Chicago Eicient-MarketsTheoryv Implications for Monetary Policy EXPECTATIONShave come to the forefront in recent discussions of macroeconomicpolicy. The theory of rationalexpectations, initially de- veloped by Muth, asserts that both firms and individuals,as rational agents, have expectationsthat will not differ significantlyfrom optimal forecasts made using all availableinformation. When rationalexpecta- tions are imposedon macroeconomicmodels, some startlingobservations emerge.Lucas finds that changesin policy affectthe parametersof many behavioralrelations; thus the use of currenteconometric models to project effects of macro policy can be misleading.'Rational expectations,to- getherwith the "naturalrate hypothesis"of Friedmanand Phelps, lend supportto the propositionthat a deterministicmonetary policy has no effect on the outputof the economy.In these models only unanticipated Note: I thank Andrew B. Abel, Dennis W. Carlton, Eugene F. Fama, Nicholas J. Gonedes, Robert E. Lucas, Jr., Donald N. McClosky, Michael Mussa, A. R. Nobay, Steven M. Sheffrin, Robert J. Shiller, and members of the Brookings panel for their helpful comments. I also appreciate the help of Lawrence Fisher, who offered data on long-term government bonds as well as advice, and Stephen Grubaugh, who provided competent research assistance. This article benefited from comments made at the Finance and Money Workshops at the University of Chicago and the Money Workshops at Harvard and Northwestern universities. The research has been sup- ported in part by the Social Science Research Council. 1. Robert E. Lucas, Jr., "Econometric Policy Evaluation: A Critique," in Karl Brunner and Allan H. Meltzer, eds., The Phillips Curve and Labor Markets, Carne- gie-Rochester Conference Series on Public Policy, vol. 1 (Amsterdam: North- Holland, 1976), pp. 19-46. 0007430317810003-0707$00.2510C Brookings Institution 708 BrookingsPapers on Economic Activity,3:1978 monetarypolicy affectsoutput, and there is some empiricalsupport for this proposition.2 Several major objectionshave been raised against rational expecta- tions theory. The cost of obtainingand analyzinginformation may be quite high for many agents in the economy, and their use of rules of thumbto form expectationsin decisionmakingmight well be appropriate, even though these expectationswould not be quite "rational."3In addi- tion, the implicationsof certainrational-expectations models-in particu- lar, the so-called equilibriummodels of the businesscycle that include both the naturalrate hypothesisand rational expectations-have been criticizedas beinghighly unrealistic. It has been arguedthat these models cannot explain the persistenceof unemployment,and they are therefore an inaccurate guide to the effects of policy.4 Although the existence of rationalexpectations in all marketsin the economycan be questioned,it seemssensible that behavior in speculative- auction markets,such as those in which bonds and common stocks are traded,would reflectavailable information. As is discussedbelow, plau- sible and less stringentconditions are needed to demonstratethat, as a useful approximationfor macroeconomicanalysis, bond and stock mar- kets are efficient-that is, pricesin these marketsfully reflectavailable in- formation.When this concept is tested on bond and stock markets,as Fama's survey in support of the efficient-marketstheory states, "con- tradictoryevidence is sparse."5 Efficient-marketstheory has major implicationsfor the econometric evaluationof policy as well as for macro forecastingmethodology.6 In- 2. See Thomas J. Sargent and Neil Wallace, "'Rational' Expectations,the Opti- mal Monetary Instrument,and the Optimal Money Supply Rule," Journal of Politi- cal Economy, vol. 83 (April 1975), pp. 241-54, and Robert J. Barro, "Unanticipated Money Growth and Unemployment in the United States," American Economic Re- view, vol. 67 (March 1977), pp. 101-15. 3. See William Poole, "Rational Expectations in the Macro Model," BPEA, 2: 1976, pp. 463-505, and Robert J. Shiller, "RationalExpectations and the Dynamic Structure of Macroeconomic Models: A Critical Review," Journal of Monetary Economics, vol. 4 (January 1978), pp. 1-44. 4. Franco Modigliani, "The Monetarist Controversy or, Should We Forsake Stabilization Policies?" American Economic Review, vol. 67 (March 1977), pp. 1-19. 5. Eugene F. Fama, "EfficientCapital Markets: A Review of Theory and Em- pirical Work,"Journal of Finance, vol. 25 (May 1970), p. 417. 6. Poole discussed some of these implications in his "Rational Expectations in the Macro Model"; this paper extends some of Poole's analysis. FredericS. Mishkin 709 deed, someof the conclusionsdeveloped by rational-expectationstheorists continueto hold up even if expectationsare not assumedto be rationalin all markets.Furthermore, efficient-markets theory implies that the macro- econometricmodels currentlyused for policy analysisand forecasting are deficientin a fundamentalway. In this articlethese issues are inspected empirically, both with statistical tests and simulationexperiments. Before the empiricalanalysis is tackled, efficient-marketstheory is examinedin more detail,7as is the importance of its applicationto bond and stock markets. Efficient-MarketsTheory The statementthat pricesfully reflectavailable information in an effi- cient marketis so generalthat it is not empiricallytestable. To make this concept testable,efficient-markets theory uses "fairgame" models of the followingform. For a securitythe excess return,Z, is definedas (1) it=Rt-R* where - = randomvariable = one-period(from t - 1 to t) nominalreturn from holding this security, including both capital gains and intermediatecash income R*= expectedRt for the securityarising from marketequilibrium. Then (2) E(Zftg|4g-)= 0, where -, = availableinformation at time t - 1. Equations 1 and 2 assertthat at today'sprice of this securitythe ex- pected excess returnsover the next period will be zero. When the equi- 7. A more extensive discussion of the theory can be found in Eugene F. Fama, Foundations of Finance: Portfolio Decisions and Securities Prices (Basic Books, 1976), and in Fama, "EfficientCapital Markets." 710 BrookingsPapers on Economic Activity, 3:1978 librium expected return (or "normal"return), R*, is viewed as deter- minedby factorslike risk and the covarianceof Rt with the overal mar- ket return,the aboveproposition can be statedin a slightlydifferent way.8 Efficient-marketstheory implies that no unexploitedprofit opportunities will exist in securitiesmarkets: at today'sprice, marketparticipants can- not expectto earna higherthan normal return by investingin thatsecurity. One importantattribute of the theory embodiedin 2 is that not all participantsin the securitiesmarkets have to use informationefficiently. Some marketparticipants could even be irrationalwithout invalidating marketefficiency. Equation2 is analogousto an arbitragecondition. Arbitrageurs who are willingto speculatemay perceiveunexploited profit opportunities and purchaseor sell securitiesuntil the price is drivento the point where 2 holds approximately.9Several costs involvedin speculatingcould drive a wedgebetween the left- and right-handsides of 2. Becausethe collection of informationis not costless, arbitrageurswould have to be compen- satedfor that cost and othersincurred in theiractivities, as well as for the risk they bear. Transactionand storage costs would also affect 2. Yet securitieshave the key featureof homogeneity,for they are merelypaper claims to income on real assets. Transactionsand holding costs should thus be negligible,while compensationof arbitrageursand the cost of informationcollection (especiallyfor the data on interestrates analyzed here) shouldbe quitesmall relative to the total value of securitiestraded. Therefore,the efficient-marketstheory of 2 is a close approximationto realityand could be extremelyuseful in macroeconomicanalysis. 8. An example can be found in the capital-asset-pricingmodel of Sharpe and Lintner discussed in Fama, "EfficientCapital Markets." 9. Depending on the arbitrage condition, 2 may not always hold exactly. In- deed, as Sanford J. Grossman and Joseph E. Stiglitz have pointed out, if 2 held exactly, efficient-marketstheory would imply a paradox. See "Information and Competitive Price Systems,"American Economic Review, vol. 66 (May 1976), pp. 246-53. If all information were fully reflected in a market according to 2, obtaining information would have zero return. Thus the market would not be able to reflect this information because it would be uncollected and hence unknown. The Gross- man and Stiglitz argument does not, however, deny the usefulness of efficient- markets theory for macroeconomic analysis. Even though their argument implies that information collection must be compensated, the difference between the right- and left-hand sides of 2 would be negligible if the cost of collecting a piece of infor- mation were small, as it is for the data on interest rates discussed in this article. FredericS. Mishkin 711 MARTINGALE IMPLICATIONS Whetherthere are significantcorrelations between past information and currentchanges in securitiesprices is the crucialissue in the empirical tests and analysisof this article.The martingalemodel, whichis a special case of efficient-marketstheory, leads to hypothesesabout these corre- lations. Equation2 implies that, if the excess return,R- R", is regressedon any past availableinformation, 5t-l, the coefficientson this past informa- tion should be zero. A common