Rational Expectations and the Paradox of Policy-Relevant Natural Experiments

41 Pages Posted: 13 Nov 2015 Last revised: 9 Feb 2018

See all articles by Gilles Chemla

Gilles Chemla

Imperial College Business School; CNRS ; Centre for Economic Policy Research (CEPR)

Chris Hennessy

London Business School

Date Written: January 2018

Abstract

In recent years, policy experiments using large microeconomic datasets have gained ground in macroeconomics. Imposing rational expectations, we examine robustness of evidence derived from ideal natural experiments applied to atomistic agents in dynamic settings. Paradoxically, once experimental evidence is viewed as sufficiently clean to use, it then becomes contaminated by ex post endogeneity: Measured responses depend upon priors and the objective function into which evidence is fed. Moreover, agents' policy beliefs become endogenously correlated with their causal parameters, severely clouding inference, e.g. sign reversals and non-invertibility may obtain. Treatment-control differences are contaminated for non-quadratic adjustment costs. Constructively, we illustrate how inference can be corrected accounting for feedback and highlight factors mitigating contamination.

Keywords: natural experiments, random assignment, econometrician, policy, endogeneity after-the-fact

JEL Classification: D78, G18, G30, G38, H00, I00, J00, K00, L00, M00, O00, Q00

Suggested Citation

Chemla, Gilles and Hennessy, Christopher, Rational Expectations and the Paradox of Policy-Relevant Natural Experiments (January 2018). Available at SSRN: https://ssrn.com/abstract=2673825 or http://dx.doi.org/10.2139/ssrn.2673825

Gilles Chemla (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 207 594 9161 (Phone)
+44 207 594 9210 (Fax)

CNRS ( email )

Dauphine Recherches en Management
Place du Marechal de Lattre de Tassigny
Paris, 75016
France
331 44054970 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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