The edifice built atop the rational expectations model also came crashing down then, and the policy response to the crisis reverted back to old-fashioned Keynesian demand-management policies (read fiscal stimulus packages), which the ‘superior’ and ‘rigorous’ rational expectation model had supposedly supplanted three decades back.
Why did the state-of-the-art rational expectations model fail? The answer lies in its deeply problematic assumptions. The model collapses all distinctions between firms, and homogenizes all individuals and commodities.
“If you homogenize all individuals and commodities in aggregate models, it is mathematically easy to build stability into the defining equations as a pure assumption,” wrote the Harvard Business School scholar Jonathan Schlefer in his 2012 book on the subject—The Assumptions Economists Make. “But it is a pure assumption. If you want, you can just as easily build instability into the model’s defining equations.”