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Misperceptions, heterogeneous expectations and macroeconomic dynamics

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  • Harrison, Richard

    ()
    (Bank of England)

  • Taylor, Tim

    ()
    (Bank of England)

Abstract

We investigate the extent to which misperceptions about the economy can become self-reinforcing and thereby contribute to time-varying macroeconomic dynamics. To do so, we build a New Keynesian model with long-horizon expectations and dynamic predictor selection. Because agents solve multi-period optimisation problems (households maximise expected lifetime utility and firms maximise the discounted flow of future profits), their current decisions are influenced by expectations of the distant future and cannot in general be characterised by the familiar Euler equations that represent the rational expectations equilibrium of these models. We assume that agents have access to a set of alternative predictors that can be used to form expectations and choose among them based on noisy measures of their recent performance. This dynamic predictor selection generates endogenous fluctuations in the proportions of agents using each predictor, contributing to macroeconomic dynamics. We explore the behaviour of our model when agents have access to two simple predictors. One of the predictors is consistent with a mistaken belief that macroeconomic variables are more persistent than implied by the fundamental shocks hitting the economy. We show that the presence of a ‘persistent predictor’ can lead to changes in beliefs which are self-reinforcing, giving rise to endogenous fluctuations in the time-series properties of the economy. Moreover, we show that such fluctuations arise even if we replace the ‘persistent predictor’ with learning under constant gain.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 449.

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Length: 41 pages
Date of creation: 18 May 2012
Date of revision:
Handle: RePEc:boe:boeewp:0449

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Keywords: Expectations; macroeconomic dynamics; heuristics;

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  1. Thomas J. Sargent, 2008. "Evolution and Intelligent Design," American Economic Review, American Economic Association, vol. 98(1), pages 5-37, March.
  2. Brock, W.A., 1995. "A Rational Route to Randomness," Working papers 9530, Wisconsin Madison - Social Systems.
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  9. Fabio Milani, 2006. "A Bayesian DSGE Model with Infinite-Horizon Learning: Do "Mechanical" Sources of Persistence Become Superfluous?," International Journal of Central Banking, International Journal of Central Banking, vol. 2(3), September.
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  11. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1036-1051, May.
  12. Sargent, Thomas J., 1991. "Equilibrium with signal extraction from endogenous variables," Journal of Economic Dynamics and Control, Elsevier, vol. 15(2), pages 245-273, April.
  13. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
  14. Thomas A. Lubik & Frank Schorfheide, 2004. "Testing for Indeterminacy: An Application to U.S. Monetary Policy," American Economic Review, American Economic Association, vol. 94(1), pages 190-217, March.
  15. Fabio Milani, 2007. "Learning and Time-Varying Macroeconomic Volatility," Working Papers 070802, University of California-Irvine, Department of Economics.
  16. Harrison, Richard & Taylor, Tim, 2012. "Non-rational expectations and the transmission mechanism," Bank of England working papers 448, Bank of England.
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Cited by:
  1. Harrison, Richard & Taylor, Tim, 2012. "Non-rational expectations and the transmission mechanism," Bank of England working papers 448, Bank of England.

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