Optimal economic institutions under rational overconfidence,with applications to the choice of exchange rate regime |
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Authors: | Carsten K. Nielsen |
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Affiliation: | Istituto di Politica Economica, Universita Cattolica, Milan, Italy. Email: Carsten.Nielsen@unicatt.it |
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Abstract: | We study the optimal choice of exchange rate regime when agents have beliefs that are mutually inconsistent. A general framework for identifying optimal policies in such situations is proposed and then used to compare fixed and floating exchange rate regimes. Agents are assumed to have diverse rational beliefs (rather than rational expectations), implying the prevalence of (rational) overconfidence. We argue that in such a situation, in comparing economic institutions, one should employ the concept of ex‐post optimality rather than that of Pareto optimality. Fixing the exchange rate is ex‐post optimal because it eliminates mistaken actions (based on mistaken beliefs). |
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Keywords: | subjective expectations rational beliefs ex‐post optimality exchange rates monetary union D01 D02 D60 D81 D84 F31 G11 |
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