Rational Expectations and the Defris‐Williams Inflationary Expectations Series

This paper evaluates the Defris‐Williams inflationary expectations series as a measure of rational expectations for the period 1973(1) to 1980(2). The results show that the series violates the rationality criterion, being an inefficient and biased predictor of inflation. By constructing an ‘information‐augmented’ D‐W series, the quantitative importance of omitted information available to consumers at the time of making their forecasts is isolated. The key omitted economic variables are found to be lagged monetary growth and unemployment or an indexation dummy which explains 70 percent of the forecast error of the D‐W series. These results suggest that a theoretically constructed expectations series may prove to be a superior measure of market expectations of inflation in Australia.