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Rational overconfidence and excess volatility in General Equilibrium

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  • Carsten Krabbe Nielsen

Abstract

Rational beliefs (in the form of WAMS measures) are expectations which though consistent with empirical observations, may deviate from the true underlying probability measure under which data is generated.We provide results on, as well as a decomposition of, WAMS measures and use this to demonstrate that an agent that adopts a non-stationary rational belief is rationally overconfident.To apply the theory to models of general equilibrium, we introduce the concept of a sunspot rational beliefs structure which can be considered as the exogenously specified part of a state process with rational beliefs. As an application, we consider an continuous state space model where agents make production decision before knowing prices. Under rational beliefs, unlike under rational expectations, mistakes persist even though all agents make forecasts that are statistically consistent with the equilibrium process. Due to the correlation of subjective beliefs brought about by the sunspots, the equilibrium exhibits excess price volatility.

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Paper provided by Econometric Society in its series Econometric Society 2004 Australasian Meetings with number 279.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:ausm04:279

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Keywords: Rational Beliefs; Rational Overconfidence; Excess Volatility;

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  1. Carsten Krabbe Nielsen, 1995. "Rational Belief Structures and Rational Belief Equilibrium," Discussion Papers 95-14, University of Copenhagen. Department of Economics.
  2. Guidolin, Massimo & Timmermann, Allan G, 2001. "Option Prices under Bayesian Learning: Implied Volatility Dynamics and Predictive Densities," CEPR Discussion Papers 3005, C.E.P.R. Discussion Papers.
  3. Dan Lovallo & Colin Camerer, 1999. "Overconfidence and Excess Entry: An Experimental Approach," American Economic Review, American Economic Association, vol. 89(1), pages 306-318, March.
  4. Mordecai Kurz & Maurizio Motolese, . "Endogenous Uncertainty and Market Volatility," Working Papers 99005, Stanford University, Department of Economics.
  5. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
  6. Carsten Krabbe Nielsen, 1997. "Floating Exchange Rates Versus a Monetary Union Under Rational Beliefs: The Role of Endogenous Uncertainty," Discussion Papers 97-22, University of Copenhagen. Department of Economics.
  7. Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
  8. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
  9. Ho-Mou Wu & Wen-Chung Guo, 2003. "Speculative trading with rational beliefs and endogenous uncertainty," Economic Theory, Springer, vol. 21(2), pages 263-292, 03.
  10. Hammond, Peter J, 1981. "Ex-ante and Ex-post Welfare Optimality under Uncertainty," Economica, London School of Economics and Political Science, vol. 48(191), pages 235-50, August.
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Cited by:
  1. Raul Caruso & Friedrich Schneider, 2012. "Brutality of Jihadist Terrorism. A contest theory perspective and empirical evidence in the period 2002-2010," DISCE - Quaderni dell'Istituto di Politica Economica ispe0061, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
  2. Luigi Pierfranco Campiglio, 2012. "Market's SINS and the European Welfare State: theory and empirical evidences," DISCE - Quaderni dell'Istituto di Politica Economica ispe0060, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
  3. John S L McCombie & Marta Spreafico, 2013. "Can only democracies enhance “Human Development”? Evidence from the Former Soviet Countries," DISCE - Quaderni dell'Istituto di Politica Economica ispe0066, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
  4. Luigi Pierfranco Campiglio, 2013. "Why Italy's saving rate became (so) low?," DISCE - Quaderni dell'Istituto di Politica Economica ispe0063, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).

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