Monetary policy and heterogeneous expectations

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.     

A simple model of a speculative housing market

We develop a simple model of a speculative housing market in which the demand for houses is influenced by expectations about future housing prices. Guided by empirical evidence, agents rely on extrapolative and regressive forecasting rules to form their expectations. The relative importance of these competing views evolves over time, subject to market circumstances. As it turns out, the dynamics of our model is driven by a two-dimensional nonlinear map which may display irregular boom and bust housing price cycles, as repeatedly observed in many actual markets. Complex interactions between real and speculative forces play a key role in such dynamic developments.     

Exchange rate puzzles: A tale of switching attractors

The rational expectations efficient market model of the exchange rate has failed empirically. In this paper, we develop a model of the exchange rate in which agents use simple forecasting rules. Based on an ex post evaluation of the relative profitability of these rules they decide whether to switch or not. In addition, transactions costs in the goods market are introduced. We show that this simple model creates great complexity in the market which is characterised by the fact that the exchange rate is disconnected from its fundamental most of the time. Finally we show that this model mimicks most of the empirical puzzles uncovered in the literature.     

Expectations, Drift, and Volatility in Evolutionary Games

This paper proposes an evolutionary model of learning in simple coordination games where expectations are the driving force of the process. As time proceeds, agents adjust their expectations through some (possibly different) updating rules, whose only requirement is that of consistency with long stationary evidence. Sporadically, expectations are also subject to arbitrary perturbation. The main point of the paper is that, due to the possibility of random drift on expectations, the evolutionary process will be subject to high volatility across equilibria. Specifically, every Nash equilibrium (even if risk- or payoff-dominated) will have significant positive weight in the long-run invariant distribution. Journal of Economic Literature Classification Numbers: C73. D83. D84.     

Business cycle amplification with heterogeneous expectations

This paper studies the implications for business cycle dynamics of heterogeneous expectations in a stochastic growth model. The assumption of homogeneous, rational expectations is replaced with a heterogeneous expectations model where a fraction of agents hold rational expectations and the remaining fraction adopt parsimonious forecasting models that are, in equilibrium, optimal within a restricted class. Our approach nests the literature on rational expectations in business cycle models with a recent approach based on adaptive learning. We demonstrate that (i.) heterogeneous expectations can lead to substantial improvement in the internal propagation of equilibrium business cycle models and (ii.) the internal propagation depends on the degree of heterogeneity. A calibrated model with heterogeneity provides a closer fit to business cycle data than its representative agent, rational expectations counterpart.     

Price‐level versus inflation targeting under model uncertainty

It has recently been suggested that price‐level targeting (PLT) may be a superior approach to monetary policy than inflation targeting (IT) due to its ability to automatically influence inflation expectations to stabilize the economy. In this paper, I analyze whether PLT dominates IT if the ability of the central bank to influence expectations is limited by model uncertainty. Specifically, I analyze how the characterization and performance of PLT and IT rules are impacted if private agents form expectations according to a model that deviates from the policy‐maker's reference model. Using robust control to derive robust rules in such a situation, I find that the performance of PLT rules deteriorate faster than that of IT rules as the degree of misspecification increases. Nevertheless, the absolute decline in performance of the PLT rules is relatively small across alternative models that are statistically plausible.     

Internal rationality, imperfect market knowledge and asset prices

We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are ‘internally rational’, i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be ‘externally rational’, i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors? expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents? market knowledge.     

Expectations and optimal monetary policy: A stability problem revisited

A landmark result in the optimal monetary policy design literature is that fundamental-based interest rate rules invariably lead to rational expectations equilibria (REE) that are not stable under adaptive learning. In this paper, we make a novel information assumption that private agents cannot observe aggregate fundamental shocks, and use simple linear forecasting rules for learning. We find that with fundamental-based rules, there exist limited information equilibria that are stable under learning. Moreover, there are multiple equilibria. Learning can be used as a selection tool to identify a unique equilibrium.     

Inflation targeting in a learning economy: An ABM perspective

This paper investigates the performances of an inflation targeting regime in a learning economy framed as an Agent-Based Model (ABM). We keep our ABM as close as possible to the original New Keynesian (NK) model, but we model the individual behaviour of the agents under procedural rationality à la Simon. Accordingly, we assume that their behaviour is guided by simple rules of thumb – or heuristics – while a continuous learning process governs the evolution of those rules. Under these assumptions that also allow the emergence of agents heterogeneity, we analyze the dynamics of the economy without assuming rational expectations, and study the role that a central bank, implementing an inflation targeting regime via a monetary policy rule, can play in the orientation of these dynamics. Consequently, our main goal is to analyse the interplay between the learning mechanisms operating at the individual level and the features and performances of the inflation targeting regime. Our results point to the prime importance of the credibility of central bank's inflation target regarding macroeconomic stabilisation, as well as the beneficial role played by that target as an anchoring device for private inflation expectations. We also establish the potential welfare cost of imperfect public information and contribute to the current debate on optimal monetary policy rules under imperfect common knowledge and uncertainty.     

Shocks,learning, and persistence

A simple model of the process of learning in a diverse economy is presented. This model produces a stylized business cycle with shocks which precipitate the learning process. All agents have the same information, which implies that this business cycle cannot be reduced by improved information flow, counter to many models of output and employment fluctuation.     

Education,overlapping generations,and the existence of equilibrium

We describe a simple aggregative model, the essential features of which are that individuals are mortal (overlapping generations) and can invest in their own training (human capital). It is shown by example that if expectations are rational then there may be a unique steady state but no competitive path starting away from the steady state.     

Price stabilizing, Pareto improving policies

One possible justification for a stabilization policy is that there is volatility in macro variables that individual agents cannot insure against. We study the simplest possible extension of the stochastic two-period, one agent and one commodity OLG model, where we have added one more period, with only one potential activity, namely, trading of contingent commodities. We assume, however, that markets are incomplete. In this case the Monetary equilibrium is not Pareto Optimal and for an open set of economies an allocation where fluctuations in realized savings are removed, Pareto dominates the monetary equilibrium. This allocation may be implemented by means of a monetary/fiscal policy. The policy considered has a simple rationale, namely that it removes some of the uncertainty that agents face by reducing price, i.e interest rate volatility. We consider two fundamental sources of such volatility, namely, respectively an objective and a subjective signal about the distribution of future endowments. The first case is when agents have rational expectations while the second case is studied in the context of agents having rational beliefs, beliefs which are consistent with empirical observations but not (necessarily) correct.     

Term structure and forward guidance as instruments of monetary policy

This paper studies a simple monetary model with a Ricardian fiscal policy in which equilibria are indeterminate if monetary policy consists solely of a rule for fixing the short-term interest rate. We introduce explicitly into the model the agents’ expectations of inflation which create the indeterminacy and show that there are two types of policies—a term structure rule or a forward guidance rule for the short rate—which lead to determinacy. The first consists in fixing the interest rates on a family of bonds of different maturities as function of realized inflation; the second consists in fixing the short-term interest rate and the expected values of the short-term interest rate for a sequence of periods into the future as a function of realized inflation. If the monetary authority chooses an inflation process that satisfies conditions derived in the paper and applies one of these rules, it anchors agents’ expectations to this process, in the sense that it is the unique inflation process compatible with equilibrium when the interest rates or expected future values of the short rate are those specified by the term structure or forward guidance rule.     

Non-falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso

We discuss the extent to which the expectation of a rare event which happens not to materialise over the sample period, but which is not rationally excludable from the set of possibilities – the peso problem –, can affect the behaviour of rational agents and the characteristics of market equilibrium. To that end we describe quantitatively the macroeconomic and financial properties of a standard equilibrium business cycle model modified to allow for a very small probability of a depression state. We produce a model specification for which both business cycle characteristics and mean financial returns are in accord with United States observations.This paper examines the possibility that the large equity premium observed in the United States may result from the expectations of a disaster event, or set of events, which happen not to have materialised in the sample period of observations. Such a possibility, which falls under the rubric of a peso phenomenon, is supported by recent empirical work of Goetzman and Jorion (1997). Using return data for a wide range of countries, these authors conclude that the high historical premium in the United States is unique, and they conjecture that it may be attributable to the fact that disastrous events affecting other financial markets (e.g. WWII for Japan, Germany, and other European countries) have largely bypassed the American economy.     

Monetary Policy,Expectations and Commitment*

Commitment in monetary policy leads to equilibria that are superior to those from optimal discretionary policies. A number of interest‐rate reaction functions and instrument rules have been proposed to implement or approximate commitment policy. We assess these rules in terms of whether they lead to a rational expectations equilibrium that is both locally determinate and stable under adaptive learning by private agents. A reaction function that appropriately depends explicitly on private sector expectations performs particularly well on both counts.     

Resource scarcity,effort allocation and environmental security: An agent-based theoretical approach

It is widely feared that environmental degradation induced by climate change may lead to economic and political insecurity through channels such as resource scarcity and mass migration. In this paper, we have developed an agent-based model to study whether resource scarcity is likely to lead to an increase in the appropriation of resources in environments where adaptive agents can allocate a fraction of their effort to predatory behavior. By enriching a production and conflict model through the introduction of separate product and resource appropriations, we show how boundedly-rational agents capable of learning can update their adaptive expectations and optimize their allocation decisions using a genetic framework. Arising from a few simple rules, the results show a high level of complexity in agents' allocation behavior with outputs ranging from no statistically significant allocation changes to widespread conflict in the environment, depending on the initial conditions and the nature of the scenarios. Overall the results support previous empirical findings that the main link between resource scarcity and conflict is through changes in the distribution of resources rather than their overall availability.     

Activist Macroeconomic Policy, Election Effects and the Formation of Expectations: Evidence from OECD Economies

We examine the explanatory power of a political—business cycle theory in which governments practice short-run policy to lessen the impact of exogenous shocks. Governments have ideological objectives with respect to macroeconomic performance, but are constrained by an augmented Phillips curve. The most prominent version, the rational partisan model, incorporates forward-looking expectations. This model can be compared to a competing model based on backward-looking expectations. Alesina and Roubini's recent advocacy of the rational model uses OECD data. Our reconsideration of the same data, updated to 1995, suggests that the adaptive expectations version offers a better explanation than the rational one.     

Consumer sentiment and countercyclical fiscal policies

We re‐explore the consequences of some popular countercyclical intervention rules in a simple Keynesian‐type macroeconomic model in which the dynamics of consumer sentiment and business cycles are intertwined. We find that fiscal policy does not only have a direct effect on national income via the well‐known Keynesian multiplier process but also an indirect effect by affecting consumer sentiment. The good news is that the indirect effect may amplify the direct effect and therefore increases a policy‐maker’s impact on national income. However, the bad news is that due to the interactions between the business cycle and the evolution of consumer sentiment, the stabilization of national income is an intricate matter.     

Learning stability in economies with heterogeneous agents

An economy exhibits structural heterogeneity when the forecasts of different agents have different effects on the determination of aggregate variables. We study the important case of economies in which agents' behavior depends on forecasts of aggregate variables and show how different forms of heterogeneity in structure, forecasts, and adaptive learning rules affect the conditions for convergence of adaptive learning towards rational expectations equilibrium. Results are applied to an overlapping generations model and a New Keynesian model of monetary policy.     

Public capital and patterns of growth in the presence of threshold externalities

This paper studies the relation between public capital accumulation and long-run economic growth. We emphasize three phenomena that may be accompanied by the presence of public capital: increasing returns, rivalry, and threshold externalities. We formulate a simple growth model that captures these features of public capital in a tractable manner. Assuming that investment for public capital financed by income taxation, we show that the threshold externalities may generate multiple equilibria, so that the pattern of growth and the realization of a specific steady-growth equilibrium are quite sensitive to the rate of income tax as well as to expectations of agents.