SPECIFICATION ERROR, PREDICTION BIAS AND RATIONAL EXPECTATIONS

In a comment on Fremling and Lott (1996), it is argued that Fremling and Lott presented a novel explanation of why aggregate forecasts can be biased, casting considerable doubt on the applicability of rational expectations. Their argument is based on some individuals making specification errors when formulating economic models, omitting relevant explanatory variables from estimation of economic relationships. Fremling and Lott's presentation of their argument is leading. In particular, they lead readers to believe that the phenomenon they identify results in aggregate/representative coefficient estimates biased toward zero, and they lead readers to believe that this causes underprediction. It is shown that although these results are possible, Fremling and Lott's argument does not guarantee this - it is also possible for aggregate coefficient estimates to be biased away from zero and/or that overprediction could result.