Variance-minimizing monetary policies with lagged price adjustment and rational expectations

This paper considers a macroeconomic model with rational expectations in which prices are incompletely flexible. Markets therefore fall to clear. In such a model monetary policy is not neutral. The variance of real and nominal quantities and interest rates is sensitive to the parameters of the feedback rule that determines the money supply. The monetary policy that achieves the goal of minimizing the steady-state variance of real output is characterized. We also examine monetary policies that are restricted in their generality and derive ‘second-best’ variance-minimizing feedback rules.     

The existence of fully rational expectations approximate equilibria with noisy price observations

Nonrevealing fully rational expectations approximate equilibria exist in microeconomic pure exchange economies in which uninformed agents have suitably dispersed noisy price observations. Such traders maximize a state-dependent expected utility conditional on the price vector they observe, the distributions of noisy price observations, and the correct equilibrium relationship between states of the world and prices. In equilibrium, aggregate excess demand is small with high probability in every state of the world (and its expectation is also small); this magnitude diminishes as the noisy price observations become more accurate. Equilibria are obtained by applying a fixed point argument to state-dependent excess demand functions which are smooth because of the noisy price observations.     

Interest-rate policy and rational expectations

The choice of monetary instrument under rational expectations is discussed in a general equilibrium model for the financial sector. It is shown that a supply rule leads to indeterminate asset prices, whereas the prices are determinate under an appropriately formulated interest-rate policy.     

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.     

Disequilibrium dynamics with monetarist price expectations

In this note we sketch the main features of the dynamic evolution of a rationed equilibrium macroeconomic model in which prices and wages respond to excess demands and inflation expectations, and the money stock is endogenous. We postulate monetarist inflation expectations, i.e., expected inflation is assumed to be equal to the current percentage rate of change of the money stock. If the system is stable, monetarist inflation expectations are asymptotically rational.     

Understanding Markov-switching rational expectations models

We develop a set of necessary and sufficient conditions for equilibria to be determinate in a class of forward-looking Markov-switching rational expectations models and we develop an algorithm to check these conditions in practice. We use three examples, based on the new-Keynesian model of monetary policy, to illustrate our technique. Our work connects applied econometric models of Markov-switching with forward looking rational expectations models and allows an applied researcher to construct the likelihood function for models in this class over a parameter space that includes a determinate region and an indeterminate region.     

On non-revealing rational expectations equilibrium

It is shown that a non-revealing rational expectations equilibrium may not be coalitionally Bayesian incentive compatible, may not be implementable as a perfect Bayesian equilibrium and may not belong to the weak fine core and thus may not be fully Pareto optimal. These negative results lead us to conclude the non-revealing rational expectations equilibrium is not a sensible solution concept. We wish to thank Dr A. Hadjiprocopis for his invaluable help with the implementation of Latex in a Unix environment. We also thank a referee for several, constructive suggestions.     

Speculative bubbles,crashes and rational expectations

Self ending speculative bubbles, i.e., speculative bubbles followed by market crashes, are consistent with the assumption of rational expectations. More generally, speculative bubbles may take all kinds of shapes. Detecting their presence or rejecting their existence is likely to prove very hard.     

Devaluation,long-term contracts and rational expectations

This paper considers the effects of devaluation and expected devaluation on output, prices and foreign exchange reserves in a small open economy with overlapping two period wage contracts and rational expectations. A devaluation has an expansionary effect on output provided it is unanticipated by at least some contracts when it occurs. Expected devaluations, however, have no effect on prices until they take place. If a devaluation is expected, but fails to take place, output is reduced. Reserves increase in response to all devaluations; but the expectation of a devaluation causes a loss of reserves prior to its expected date.     

Disequilibrium rational expectations: Examples of unemployment with inflation

In this paper, we present a simple dynamic general disequilibrium model which generates both unemployment and inflation as a stationary long-run equilibrium. Rational expectations (in the mean) are an essential part of this equilibrium. Policy remedies are examined. By means of an example, it is shown that rational expectations are consistent with depressed economic activity and that government policy can play an important role. It is entirely possible for inflation and unemployment to persist indefinitely.     

Asset price volatility and trading volume with rational beliefs

Summary. This paper develops a model of speculative trading in a large economy with a continuum of investors. In our model the investors are assumed to have diverse beliefs which are rational in the sense of being compatible with observed data. We demonstrate the existence of price amplification effects and show that the equilibrium prices can be higher or lower than the rational expectation equilibrium price. It is also shown that trading volume is positively related to the directions of price changes. Moreover, we study how asset price volatility and trading volume are influenced by belief structures, short selling constraints and the amount of fund available for investment.Received: 23 January 2003, Revised: 30 April 2003, JEL Classification Numbers: D84, G12.We are grateful to Professors Mordecai Kurz, Kenneth Arrow, Kenneth Judd, Carsten Nielsen, Maurizio Motolese, Mark Garmaise, Jean-Michel Grandmont, Peter Hammond, Karl Shell, Jan Werner and participants of the Society for the Advancement of Economic Theory (SAET) Conference and Stanford Institute of Theoretical Economics (SITE) Conference for many helpful suggestions. Correspondence to: H.-M. Wu     

Competitive equilibrium hyperinflation under rational expectations

This paper shows that a competitive equilibrium model, where a representative agent maximizes welfare, expectations are rational and markets are in equilibrium can account for several hyperinflation stylized facts. The theory is built by combining two hypotheses, namely, a fiscal crisis that requires printing money to finance an increasing public deficit and a predicted change in an unsustainable fiscal regime.We thank an anonymous referee for very helpful comments. A. B. Cunha acknowledges financial support from the Brazilian Council of Science and Technology (CNPq).     

Confident expectations, rational expectations and the optimal conduct of monetary policy

Under what conditions central banks can afford to deviate from announced targets without losing their reputation is analyzed. For this, the public must have something like ‘confident expectations' vis-a-vis monetary policy and central banks have to behave accordingly. The paper shows that it can be rational for the public and welfare-increasing for the society to retain ‘confident expectations' instead of switching to rational expectations, when central banks have gained long-run reputation. At the end of the paper, alternative optimal money supply rules are compared in a dynamic optimization framework. © 1998 Elsevier Science B.V. All rights reserved.     

On multiple equilibria and the rational expectations hypothesis

Summary This paper analyzes through a simple two-period model the fact that, if some agents hold inside money intertemporally, the second-period normalization matters. Thus, there are several equilibria of the second-period economy, indexed by the level of inflation. A concept of equilibrium acknowledging this fact, and requiring that agents put some weight on any of the possible second-period equilibrium price vectors is developed. Such an equilibrium is shown to exist, and is illustrated by an example.This a revised version of chapter three of my Ph.D. dissertation. I would like to thank David Cass, Atsushi Kajii, George Mailath and Shinichi Suda for helpful discussions and comments. Thanks are also due to Jean-Michel Grandmont who pointed out mistakes in a previous version. All remaining mistakes are of course my own. Financial support from a CARESS scholarship at the University of Pennsylvania is gratefully acknowledged.     

Learning rational expectations in an asset market

Will traders in a risky asset market learn Muthian expectations when they initially lack the necessary information? If some traders learn from their observations, will market dynamics depend only on “fundamentals,” as implied by the Efficient Market Hypothesis? This paper shows that at any finite point in time the answer to these questions is “no”. The context is a constant absolute risk aversion model with two kinds of traders and asymmetric information. The market converges asymptotically to a rational expectations equilibrium where prices depend only on fundamentals and the market is efficient.