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The rationality of expectations formation and excess volatility

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Abstract

I establish, in simple deterministic overlapping generations economies, that if each agent holds rationally formed expectations in the sense that any other expectations justifying his choices imply a smaller likelihood for the history he observes with limited memory, then there are rationally formed expectations equilibria exhibiting an excess volatility that no rational expectations equilibrium can match. Given that the limited records or finite memory case may arguably be the relevant one from a positive viewpoint, this result suggests that the possibility of excess volatility as an equilibrium phenomenon has been downplayed by the use of the rational expectations hypothesis.

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File URL: ftp://mse.univ-paris1.fr/pub/mse/CES2008/B08019.pdf
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Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number b08019.

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Length: 23 pages
Date of creation: Feb 2008
Date of revision:
Handle: RePEc:mse:cesdoc:b08019

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Keywords: Expectations; rationality; volatility.;

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