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Expectations, Learning And Business Cycle Fluctuations

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  • Stefano Eusepi

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  • Bruce Preston

    ()

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    Abstract

    This paper develops a theory of expectations-driven business cycles based on learning. Agents have incomplete knowledge about how market prices are determined and shifts in expectations of future prices affect dynamics. In a real business cycle model, the theoretical framework amplifies and propagates technology shocks. Improved correspondence with data arises from dynamics in beliefs being themselves persistent and because they generate strong intertemporal substitution effects in consumption and leisure. Output volatility is comparable with a rational expectations analysis with a standard deviation of technology shock that is 20 percent smaller, and has substantially more volatility in investment and hours. Persistence in these series is captured, unlike in standard models. Inherited from real business cycle theory, the benchmark model suffers a comovement problem between consumption, hours, output and investment. An augmented model that is consistent with expectations-driven business cycles, in the sense of Beaudry and Portier (2006), resolves these counterfactual predictions.

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    File URL: http://cbe.anu.edu.au/research/papers/camawpapers/Papers/2008/Eusepi_Preston_202008.pdf
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    Bibliographic Info

    Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2008-20.

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    Length: 62 pages
    Date of creation: Jul 2008
    Date of revision:
    Handle: RePEc:een:camaaa:2008-20

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    1. Bruce Preston, 2003. "Learning about monetary policy rules when long-horizon expectations matter," Working Paper 2003-18, Federal Reserve Bank of Atlanta.
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