May 2002

IZA DP No. 498: Individual Rationality and Learning: Welfare Expectations in East Germany Post-Reunification

published in: Canadian Journal of Economics, 2009, 42 (4), 1326 - 1346

In this paper we test the Rational Expectations hypothesis using longitudinal data on expectations and realizations of individual welfare for East Germans in the years following reunification. German reunification was unexpected and delivered a large shock to the future prospects of the inhabitants of the former East Germany. We therefore take it as a 'natural' experiment through which to study the rationality of expectations. Our results show that East Germans significantly over-estimated the welfare gains immediately following reunification. The prediction error was largest for the young, the poorly educated and those with children. However, expectations and realizations of life satisfaction in East Germany had converged by 1995, at a level considerably below that of West Germans. We hence conclude that expectations were close to rational after the dust of reunification had settled, but that expectations are not likely to be rational in times of great transition or volatility.