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Testing Near-Rationality Using Detail Survey Data

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  • Stefan Palmqvist
  • Michael F. Bryan
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    Abstract

    This paper considers the evidence of “near-rationality†in household inflation expectations, as described by Akerlof, Dickens, and Perry (2000), hereafter ADP. According to ADP, the economic incentive to anticipate inflation varies from agent to agent, and as inflation falls, some agents stop trying to accurately predict inflation (“hyper-rationalâ€) and either underweight it or, in the extreme, ignore it altogether (“nearly rationalâ€). A key implication of the ADP model is that a particular rate of inflation minimizes unemployment in the long-run. In this paper, we bring the idea described by ADP to detailed survey data on household inflation expectations for the U.S. and Sweden, two countries where the existence of ADP-type near-rationality has been identified in earlier research. We find that the survey data do not, in general, support the specific form of near-rationality suggested by ADP. However, we also show that inflation expectations are not distributed across households in a smooth and continuous way. Rather, households appear to hold inflation expectations that tend to discrete, and largely fixed “focal points,†suggesting that a substantial share of both Swedish and U.S. households do not form precise inflation predictions, but instead gauge inflation prospects in rather qualitative terms. We further document that in Sweden, the combination of a low inflation environment, coupled with an inflation target, has been accompanied by a disproportionately high proportion of households reporting the expectation of no inflation, consistent with one type of “nearly rational†behavior posited by ADP. However, a similarly low inflation trend in the U.S., which does not have an explicit inflation target, reveals no such rise in the proportion of households expecting no inflation. This observation suggests that how the central bank communicates its inflation objective may influence inflation expectations independently of the inflation trend they actually pursue.

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    Bibliographic Info

    Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 371.

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    Date of creation: 11 Nov 2005
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    Handle: RePEc:sce:scecf5:371

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    Keywords: Inflation expectations; inflation targeting; survey data;

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    1. Figlewski, Stephen & Wachtel, Paul, 1983. "Rational Expectations, Informational Efficiency, and Tests Using Survey Data: A Reply [The Formation of Inflationary Expectations]," The Review of Economics and Statistics, MIT Press, vol. 65(3), pages 529-31, August.
    2. N. Gregory Mankiw & Ricardo Reis & Justin Wolfers, 2004. "Disagreement about Inflation Expectations," NBER Chapters, in: NBER Macroeconomics Annual 2003, Volume 18, pages 209-270 National Bureau of Economic Research, Inc.
    3. Jonung, Lars, 1981. "Perceived and Expected Rates of Inflation in Sweden," American Economic Review, American Economic Association, vol. 71(5), pages 961-68, December.
    4. Figlewski, Stephen & Wachtel, Paul, 1981. "The Formation of Inflationary Expectations," The Review of Economics and Statistics, MIT Press, vol. 63(1), pages 1-10, February.
    5. Dietrich, J Kimball & Joines, Douglas H, 1983. "Rational Expectations, Informational Efficiency, and Tests Using Survey Data: A Comment [The Formation of Inflationary Expectations]," The Review of Economics and Statistics, MIT Press, vol. 65(3), pages 525-29, August.
    6. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
    7. Yash P. Mehra, 2002. "Survey measures of expected inflation : revisiting the issues of predictive content and rationality," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 17-36.
    8. George A. Akerlof & William T. Dickens & George L. Perry, 2000. "Near-Rational Wage and Price Setting and the Long-Run Phillips Curve," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(1), pages 1-60.
    9. Christopher D. Carroll, 2001. "The Epidemiology of Macroeconomic Expectations," NBER Working Papers 8695, National Bureau of Economic Research, Inc.
    10. Kenneth N Kuttner, 2004. "A Snapshot of Inflation Targeting in its Adolescence," RBA Annual Conference Volume, in: Christopher Kent & Simon Guttmann (ed.), The Future of Inflation Targeting Reserve Bank of Australia.
    11. Lundborg, Per & Sacklén, Hans, 2003. "Low-Inflation Targeting and Unemployment Persistence," Working Paper Series 188, Trade Union Institute for Economic Research.
    12. Keane, Michael P & Runkle, David E, 1990. "Testing the Rationality of Price Forecasts: New Evidence from Panel Data," American Economic Review, American Economic Association, vol. 80(4), pages 714-35, September.
    13. Michael F. Bryan & Guhan Venkatu, 2001. "The curiously different inflation perspectives of men and women," Economic Commentary, Federal Reserve Bank of Cleveland, issue Nov.
    14. Souleles, Nicholas S, 2004. "Expectations, Heterogeneous Forecast Errors, and Consumption: Micro Evidence from the Michigan Consumer Sentiment Surveys," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(1), pages 39-72, February.
    15. Lundborg, Per & Sacklén, Hans, 2001. "Is There a Long Run Unemployment-Inflation Trade-off in Sweden?," Working Paper Series 173, Trade Union Institute for Economic Research.
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