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Model reference adaptive expectations in Markov-switching economies

  • Carravetta, Francesco
  • Sorge, Marco M.

This paper offers a theory of model reference adaptive beliefs as a selection device in Markov-switching economies under equilibrium indeterminacy. Consistent with the classical rational choice paradigm, our theory requires that endogenous expectations be replaced with a general-measurable function of the observable states of the model, to be determined optimally. This forecasting function is derived as the regime-independent feedback control minimizing the mean-square deviation of the equilibrium path from the corresponding perfect-foresight state motion (the reference model). We show that model reference adaptive expectations always generate a rational expectations equilibrium, irrespective of the presence of nonlinearities and/or imperfect information. Under equilibrium indeterminacy, this forecasting mechanism enforces the unique mean-square stable solution producing nearly perfect-foresight dynamics.

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Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 32 (2013)
Issue (Month): C ()
Pages: 551-559

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Handle: RePEc:eee:ecmode:v:32:y:2013:i:c:p:551-559
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