Money Illusion and Rational Expectations: New Evidence from Well Known Survey Data
AbstractThis paper provides further evidence in favor of less than fully rational expectations by making use two instruments, one quite well known, and the other more novel, namely survey data on inflation expectations and Smooth Transition Error Correction Models (STECMs). We use the so called ‘probabilistic approach’ to derive a quantitative measure of expected inflation from qualitative survey data for France, Italy and the UK. The United States are also included by means of the Michigan Survey of Consumers’ expectations series. First, we perform the standard tests to assess the ‘degree of rationality’ of consumers’ inflation forecasts. Afterwards, we specify a STECM of the forecast error, and we quantify the strategic stickiness in the long-run adjustment process of expectations stemming from money illusion. Our evidence is that consumers’ expectations do not generally conform to the prescriptions of the rational expectations hypothesis. In particular, we find that the adjustment process towards the long-run equilibrium is highly nonlinear and it is asymmetric with respect to the size of the past forecast errors. We interpret these findings as supporting the money illusion hypothesis.
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Bibliographic InfoPaper provided by Department of Economics, University of Siena in its series Department of Economics University of Siena with number 606.
Date of creation: Dec 2010
Date of revision:
Nonlinear error correction; inflation expectations; sticky expectations;
Find related papers by JEL classification:
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models &bull Diffusion Processes
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
- E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-01-23 (All new papers)
- NEP-CBA-2011-01-23 (Central Banking)
- NEP-MAC-2011-01-23 (Macroeconomics)
- NEP-MON-2011-01-23 (Monetary Economics)
- NEP-UPT-2011-01-23 (Utility Models & Prospect Theory)
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