STABILISATION POLICY,RATIONAL EXPECTATIONS AND PRICE‐LEVEL VERSUS INFLATION TARGETING: A SURVEY

We survey literature comparing inflation targeting (IT) and price‐level targeting (PT) as macroeconomic stabilisation policies. Our focus is on New Keynesian models and areas that have seen significant developments since Ambler's (2009, Price‐level targeting and stabilisation policy: a survey. Journal of Economic Surveys 23(5): 974–997) survey: optimal monetary policy; the zero lower bound; financial frictions and transition costs of adopting a PT regime. Ambler's conclusion that PT improves social welfare in New Keynesian models is fairly robust, but we note an interesting split in the literature: PT consistently outperforms IT in models where policymakers commit to simple Taylor‐type rules, but results in favour of PT when policymakers minimise loss functions are overturned with small deviations from the baseline model. Since the beneficial effects of PT appear to hang on the joint assumption that agents are rational and the economy New Keynesian, we discuss survey and experimental evidence on rational expectations and the applied macro literature on the empirical performance of New Keynesian models. Overall, the evidence is not clear‐cut, but we note that New Keynesian models can pass formal statistical tests against macro data and that models with rational expectations outperform those with behavioural expectations (i.e. heuristics) in direct statistical tests. We therefore argue that policymakers should continue to pay attention to PT.     

Precautionary behavior and consumer information: A Markov process approach

This paper explores the role of consumer confidence in the equilibrium of a dynamic macroeconomic growth model with rational expectations. Consumers face an uncertain future income stream due to a Markov stochastic process that affects production. Changes in the properties of this process change consumer information sets and optimal policies in the rational expectations format. Increases in “persistence” in the shock process are considered; this is identified with the consumer's subjective assessment of future economic conditions. Two cases are considered: where either good or bad states of the process are more likely to persist into the future, and where bad states persist unconditionally at the expense of good. Consistent with earlier treatments of savings under uncertainty (Barsky, Mankiw and Zeldes 1986, and Skinner 1988), the consumer's response to increased income uncertainty is to exhibit precautionary saving behavior. The infinite-horizon growth model format used offers significant improvement over other finite-horizon life cycle models. Specifically, the model is a full general equilibrium model and the solutions are rational expectations solutions. The technique also is easily adapted to other recursive decision problems under uncertainty.     

Testing Steady‐State Restrictions of Linear Rational Expectations Models when Data are Highly Persistent*

Steady‐state restrictions are commonly imposed on highly persistent variables to achieve stationarity prior to confronting rational expectations models with data. However, the resulting steady‐state deviations are often surprisingly persistent indicating that some aspects of the underlying theory may be empirically problematic. This paper discusses how to formulate steady‐state restrictions in rational expectations models with latent forcing variables and test their validity using cointegration techniques. The approach is illustrated by testing steady‐state restrictions for alternative specifications of the New Keynesian model and shown to be able to discriminate between different assumptions on the sources of the permanent shocks.     

A qualitative response analysis of UK firms' employment and output decisions

This paper investigates firms' employment and output decisions and presents some empirical evidence concerning the rationality of firms' expectations. The dymanic model is based on the assumptions of convex adjustment costs and monopolistic competition in the product market. The results are obtained using categorical information on individual firms contained in business surveys collected by the Confederation of British Industry. Ordered probit models are used to estimate the employment and output equations. We find that expected demand is a critical determinant of firms' decisions, the effect of changes in cost conditions is not as well determined, and the data are not consistent with the rational expectations hypothesis.     

Constructing Multi‐Country Rational Expectations Models

This article considers some of the technical issues involved in using the global vector autoregression (GVAR) approach to construct a multi‐country rational expectations (RE) model and illustrates them with a new Keynesian model for 33 countries estimated with quarterly data over the period 1980–2011. The issues considered are: the measurement of steady states; the determination of exchange rates and the specification of the short‐run country‐specific models; the identification and estimation of the model subject to the theoretical constraints required for a determinate rational expectations solution; the solution of a large RE model; the structure and estimation of the covariance matrix and the simulation of shocks. The model used as an illustration shows that global demand and supply shocks are the most important drivers of output, inflation and interest rates in the long run. By contrast, monetary or exchange rate shocks have only a short‐run impact in the evolution of the world economy. The article also shows the importance of international connections, directly as well as indirectly through spillover effects. Overall, ignoring global inter‐connections as country‐specific models do, could give rise to misleading conclusions.     

Solving generalized multivariate linear rational expectations models

We generalize the linear rational expectations solution method of Whiteman (1983) to the multivariate case. This facilitates the use of a generic exogenous driving process that must only satisfy covariance stationarity. Multivariate cross-equation restrictions linking the Wold representation of the exogenous process to the endogenous variables of the rational expectations model are obtained. We argue that this approach offers important insights into rational expectations models. We give two examples in the paper—an asset pricing model with incomplete information and a monetary model with observationally equivalent monetary-fiscal policy interactions. We relate our solution methodology to other popular approaches to solving multivariate linear rational expectations models, and provide user-friendly code that executes our approach.     

Alternative procedures for converting qualitative response data to quantitative expectations: An application to Australian manufacturing

This paper analyses and extends alternative procedures for converting qualitative expectations responses to quantitative expectations. A number of conversion procedures is investigated, including the probability model, the time-varying parameter probability model, and the regression approach. The informational content of the survey expectations is compared with simple time series models. It is found that the expectations models are superior for many series, both in terms of producing lower forecast root mean square error (RMSE) values and in detecting turning points in the actual data. Survey expectations are also tested for rational expectations in aggregate using the orthogonality test.     

Precautionary motives and portfolio decisions

This paper studies the empirical relevance of precautionary and other motives for household portfolio behaviour using recent panel data from the Netherlands. Dutch households' portfolios exhibit low degrees of risk taking and diversification. It is possible that this is the outcome of a rational, precautionary response to unavoidable exposure to background risk (stemming from the labour market or health conditions, etc.). We consider as alternative explanations liquidity needs and habits. The endogenous variable is the fraction of clearly safe in total financial assets at the household level. Parametric and semi‐parametric censored regression models for pooled cross‐sections and random and fixed effects models for panel data show that both heteroscedasticity and unobserved heterogeneity are of major importance in the data. With subjective indicators of income uncertainty we find a limited role for precautionary motives. Copyright © 2002 John Wiley & Sons, Ltd.     

The empowerment expectation–perception gap: An examination of three alternative models

Previous empowerment research has focused on subordinate perceptions of empowering leadership and its outcomes. Met‐expectations theory suggests that subordinate expectations of leader behaviours are essential in forming their a posteriori evaluations. To address the lack of investigation of individual expectations in the empowerment literature, in this study, we explore how subordinates' empowerment expectations and perceptions combine to influence their job satisfaction and psychological empowerment based on three alternative, theoretically derived met‐expectation models, namely, the disconfirmation model, the ideal‐point model, and the experiences‐only model. The results of a 2‐stage study of 114 respondents indicate that employees are more satisfied with their work when perceived empowerment exceeds expectations. However, both empowerment perceptions and expectations positively contribute to higher psychological empowerment. We then discuss implications and directions for future research.     

Quasi‐rational and ex ante price expectations in commodity supply models: an empirical analysis of the US broiler market

A statistically optimal inference about agents' ex ante price expectations within the US broiler market is derived using futures prices of related commodities along with a quasi‐rational forecasting regression equation. The modelling approach, which builds on a Hamilton‐type framework, includes endogenous production and allows expected cash price to be decomposed into anticipated and unanticipated components. We therefore infer the relative importance of various informational sources in expectation formation. Results show that, in addition to the quasi‐rational forecast, the true supply shock, future prices, and ex post commodity price forecast errors have, at times, been influential in broiler producers' price expectations. Copyright © 2003 John Wiley & Sons, Ltd.     

A preliminary exploration of the effects of rational factors and behavioral biases on the managerial choice to invest in corporate responsibility

We explore a possible decision‐making process in which mixes of rational and non‐rational factors affect the choice made by a firm's management to invest in corporate responsibility. We propose that the rational factors affecting the decision‐makers' investment choice are: (a) moral choice; (b) risk management; (c) consequential changes that would be required in corporate structure or production processes; and (d) long‐term versus short‐term considerations. The non‐rational behavioral biases that we suggest affecting the decision‐makers' investment choice are: (a) attitude to risk, (b) status quo bias, (c) subjective discounting, and (d) myopic loss‐aversion. Copyright © 2011 John Wiley & Sons, Ltd.     

The role of beliefs in inference for rational expectations models

This paper discusses inference for rational expectations models estimated via minimum distance methods by characterizing the probability beliefs regarding the data generating process (DGP) that are compatible with given moment conditions. The null hypothesis is taken to be rational expectations and the alternative hypothesis to be distorted beliefs. This distorted beliefs alternative is analyzed from the perspective of a hypothetical semiparametric Bayesian who believes the model and uses it to learn about the DGP. This interpretation provides a different perspective on estimates, test statistics, and confidence regions in large samples, particularly regarding the economic significance of rejections in rational expectations models. A suggestive application to the equity premium puzzle is examined.     

Experimental evidence on inflation expectation formation

Using laboratory experiments within a New Keynesian sticky price framework, we study the process of inflation expectation formation. We focus on adaptive learning and rational expectations contrary to the previous literature that mostly studied simple heuristics. Using a test for rational expectations that allows heterogeneity of expectations we find that we cannot reject rationality for about 40% of subjects. More than 20% of subjects are also best described by adaptive learning models, where they behave like econometricians and update their model estimates every period. However, rather than using a single forecasting model, switching between models describes their behavior better. Switching is more likely to occur when experimental economy is in a recession.     

Biased Bayesian learning with an application to the risk-free rate puzzle

Based on the axiomatic framework of Choquet decision theory, we develop a closed-form model of Bayesian learning with ambiguous beliefs about the mean of a normal distribution. In contrast to rational models of Bayesian learning the resulting Choquet Bayesian estimator results in a long-run bias that reflects the agent's ambiguity attitudes. By calibrating the standard equilibrium conditions of the consumption based asset pricing model we illustrate that our approach contributes towards a resolution of the risk-free rate puzzle. For a plausible parameterization we obtain a risk-free rate in the range of 3.5–5%. This is 1–2.5% closer to the empirical risk-free rate than according calibrations of the rational expectations model.     

Weak Identification of Forward‐looking Models in Monetary Economics*

Recently, single‐equation estimation by the generalized method of moments (GMM) has become popular in the monetary economics literature, for estimating forward‐looking models with rational expectations. We discuss a method for analysing the empirical identification of such models that exploits their dynamic structure and the assumption of rational expectations. This allows us to judge the reliability of the resulting GMM estimation and inference and reveals the potential sources of weak identification. With reference to the New Keynesian Phillips curve of Galí and Gertler [Journal of Monetary Economics (1999) Vol. 44, 195] and the forward‐looking Taylor rules of Clarida, Galí and Gertler [Quarterly Journal of Economics (2000) Vol. 115, 147], we demonstrate that the usual ‘weak instruments’ problem can arise naturally, when the predictable variation in inflation is small relative to unpredictable future shocks (news). Hence, we conclude that those models are less reliably estimated over periods when inflation has been under effective policy control.     

On the Epidemiological Microfoundations of Sticky Information*

We estimate and compare two models in which households periodically update their expectations. The first model assumes that households update their expectations towards survey measures. In the second model, households update their expectations towards rational expectations (RE). While the literature has used these specifications indistinguishably, we argue that there are important differences. The two models imply different updating probabilities, and the data seem to prefer the second one. We then analyse the properties of both models in terms of mean expectations, median expectations, and a measure of disagreement among households. The model with periodical updates towards RE also seems to fit the data better along these dimensions.     

Sentiment and the U.S. business cycle

Psychological factors are commonly believed to play a role on cyclical economic fluctuations, but they are typically omitted from state-of-the-art macroeconomic models.This paper introduces “sentiment” in a medium-scale DSGE model of the U.S. economy and tests the empirical contribution of sentiment shocks to business cycle fluctuations.The assumption of rational expectations is relaxed. The paper exploits, instead, observed data on expectations in the estimation. The observed expectations are assumed to be formed from a near-rational learning model. Agents are endowed with a perceived law of motion that resembles the model solution under rational expectations, but they lack knowledge about the solution’s reduced-form coefficients. They attempt to learn those coefficients over time using available time series at each point in the sample and updating their beliefs through constant-gain learning. In each period, however, they may form expectations that fall above or below those implied by the learning model. These deviations capture excesses of optimism and pessimism, which can be quite persistent and which are defined as sentiment in the model. Different sentiment shocks are identified in the empirical analysis: waves of undue optimism and pessimism may refer to expected future consumption, future investment, or future inflationary pressures.The results show that exogenous variations in sentiment are responsible for a sizable (above forty percent) portion of historical U.S. business cycle fluctuations. Sentiment shocks related to investment decisions, which evoke Keynes’ animal spirits, play the largest role. When the model is estimated imposing the rational expectations hypothesis, instead, the role of structural investment-specific and neutral technology shocks significantly expands to capture the omitted contribution of sentiment.     

Analysts' utilization of historical earnings information

This study examines whether security analysts (in)efficiently utilize the information contained in past series of annual and quarterly earnings in producing earnings forecasts. To do so, it investigates whether equal-weighted combinations of security analysts' forecasts with forecasts from statistical models based on historical earnings are superior, both in terms of being a better surrogate for the market's expectations of earnings and of accuracy, to forecasts from either one of these two sources. The empirical findings indicate that, although analysts' forecasts are superior to forecasts from statistical models, performance can be improved—both in terms of accuracy and also of being a better surrogate for market earnings expectations—by combining analysts' forecasts with forecasts from statistical models based on past quarterly earnings. Improvements in proxying for market earnings expectations were obtained even when analysts' forecasts made in June of the forecast year were used in the combinations. An implication of these findings is that investors can improve their investment decisions by using an average of the mean analysts' forecasts and the forecast produced by a time-series model of quarterly earnings in their investment decisions.     

Issue Information

Much research studies US inflation history with a trend‐cycle model with unobserved components, where the trend may be viewed as the Fed's evolving inflation target or long‐horizon expected inflation. We provide a novel way to measure the slowly evolving trend and the cycle (or inflation gap), by combining inflation predictions from the Survey of Professional Forecasters (SPF) with realized inflation. The SPF forecasts may be treated either as rational expectations (RE) or updating according to a sticky information (SI) law of motion. We estimate RE and SI state‐space models with stochastic volatility on samples of consumer price index and gross national product/gross domestic product deflator inflation and the associated SPF inflation predictions using a particle Metropolis–Markov chain Monte Carlo sampler. The trend converges to 2% and its volatility declines over time—two tendencies largely complete by the late 1990s.     

The Endogenous Economist:

A bstract . In the social sciences there exist links of communication and influence between the scientists and the actors of the modelled social systems. Social scientists are therefore endogenous parts of the systems which they study. Theories and models shouid be self-referential. The treatment of information in the rational choice models of the new classical theory, with its core assumption of rational expectations , has stopped short of extending the concept of endogeneity to the economists themselves. Economic theory proceeds on the assumption that it yields the true model and that the actors in the system share this same model even though economists have not yet agreed on this unique model. Moreover, it assumes that economists' disputes about the true model do not prompt the actors of the system to take positions and opt for one or the other of the discussed models. The use of a unique model perspective to interpret the response of financial markets to monetary announcements leads to inconclusive interpretations of the evidence. These findings are better interpreted as the result of multi model competition that has spilled over from academic science to the financial markets themselves.