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Transformations of the state variable and learning dynamics

  • Shurojit Chatterji
  • Ignacio N. Lobato

This article studies dynamics in a model where agents forecast a one dimensional variable via ordinary least squares regressions on the lagged values of the state variable. We study the stability properties of alternative transformations of the state variable that the agent can endogenously set forth. We study the consequences on the economy's stability of the typical transformations that an econometrician would attemp, such as differencing, detrending, or taking instantaneous concave transformations, such as logarithms. Surprinsingly, for the considered class of economies, we found that these transformations are destabilizing, whereas alternative transformations, which an econometrician would never consider, such as convex transformations, are stabilizing. Therefore, we ironically find that in our set-up. an active agent, who is concerned about learning the economy's dynamics and transforms the state variable, in an attempt to improve forecasting, is more likely to deviate from the steady state than a passive agent.

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Article provided by The International Society for Economic Theory in its journal International Journal of Economic Theory.

Volume (Year): 6 (2010)
Issue (Month): 4 ()
Pages: 385-403

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Handle: RePEc:bla:ijethy:v:6:y:2010:i:4:p:385-403
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  1. Chatterji, Shurojit & Chattopadhyay, Subir, 2000. "Global stability in spite of "local instability" with learning," Journal of Mathematical Economics, Elsevier, vol. 33(2), pages 155-165, March.
  2. Coulson, N Edward & Robins, Russell P, 1987. "A Test of the First Difference Transformation in Time Series Models," The Review of Economics and Statistics, MIT Press, vol. 69(4), pages 723-26, November.
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  9. Van Zandt, Timothy & Lettau, Martin, 2003. "Robustness Of Adaptive Expectations As An Equilibrium Selection Device," Macroeconomic Dynamics, Cambridge University Press, vol. 7(01), pages 89-118, February.
  10. Lucas, Robert E, Jr, 1986. "Adaptive Behavior and Economic Theory," The Journal of Business, University of Chicago Press, vol. 59(4), pages S401-26, October.
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  12. Frydman, Roman, 1982. "Towards an Understanding of Market Processes: Individual Expectations, Learning, and Convergence to Rational Expectations Equilibrium," American Economic Review, American Economic Association, vol. 72(4), pages 652-68, September.
  13. Spear, Stephen E., 1985. "Rational expectations in the overlapping generations model," Journal of Economic Theory, Elsevier, vol. 35(2), pages 251-275, August.
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