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Heterogeneity and learning with complete markets

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  • Sergio Santoro

    ()
    (Bank of Italy)

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    Abstract

    We study an endowment economy with complete markets and heterogeneous agents who do not have rational expectations, but form their beliefs using adaptive learning algorithms that may differ from one individual to another. We show that market completeness allows agents to smooth consumption across states of nature, but not across time, and that the initial wealth distribution is not enough to pin down the long-run equilibrium. Consequently, initial differences in beliefs create persistent consumption imbalances that are not grounded in fundamentals. In some cases these imbalances are eventually unsustainable: the debt of one of the agents would grow without bounds, and binding borrowing limits are necessary to prevent Ponzi schemes. Finally, we find that our slight departure from rational expectations affects efficiency properties of the competitive equilibrium: if the social welfare function attaches fixed Pareto weights to the different individuals, there are configurations of individual expectations under which society is better off with financial autarky than with complete markets. The first best can be restored by introducing a distortionary tax on borrowing, which transfers consumption from the more optimistic agent to the other.

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    File URL: http://www.bancaditalia.it/pubblicazioni/econo/temidi/td11/td806_11/en_td_806_11/en_tema_806.pdf
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    Bibliographic Info

    Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 806.

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    Date of creation: Apr 2011
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    Handle: RePEc:bdi:wptemi:td_806_11

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    Web page: http://www.bancaditalia.it
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    Keywords: learning; heterogeneous agents; complete markets;

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    1. Pfajfar, Damjan & Santoro, Emiliano, 2010. "Heterogeneity, learning and information stickiness in inflation expectations," Journal of Economic Behavior & Organization, Elsevier, vol. 75(3), pages 426-444, September.
    2. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2008. "Stock Market Volatility and Learning," Working Papers 336, Barcelona Graduate School of Economics.
    3. Seppo Honkapohja & Kaushik Mitra, 2002. "Learning Stability in Economies with Heterogenous Agents," CESifo Working Paper Series 772, CESifo Group Munich.
    4. George W. Evans & Seppo Honkapohja, 2003. "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 807-824, October.
    5. Assenza, Tiziana & Berardi, Michele, 2009. "Learning in a credit economy," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1159-1169, May.
    6. Marcet, A. & Marimon, R., 1998. "Recursive Contracts," Economics Working Papers eco98/37, European University Institute.
    7. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
    8. John M. Roberts, 1998. "Inflation expectations and the transmission of monetary policy," Finance and Economics Discussion Series 1998-43, Board of Governors of the Federal Reserve System (U.S.).
    9. Luca Rigotti & Chris Shannon, 2005. "Uncertainty and Risk in Financial Markets," Econometrica, Econometric Society, vol. 73(1), pages 203-243, 01.
    10. Branch, William A., 2007. "Sticky information and model uncertainty in survey data on inflation expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 31(1), pages 245-276, January.
    11. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
    12. Berardi, Michele, 2007. "Heterogeneity and misspecifications in learning," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3203-3227, October.
    13. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1105-1129, September.
    14. William A. Branch, 2004. "The Theory of Rationally Heterogeneous Expectations: Evidence from Survey Data on Inflation Expectations," Economic Journal, Royal Economic Society, vol. 114(497), pages 592-621, 07.
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