IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this article

Internal rationality, imperfect market knowledge and asset prices

  • Adam, Klaus
  • Marcet, Albert

We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be 'externally rational', i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors[modifier letter apostrophe] expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents[modifier letter apostrophe] market knowledge.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.sciencedirect.com/science/article/pii/S0022053110001638
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 146 (2011)
Issue (Month): 3 (May)
Pages: 1224-1252

as
in new window

Handle: RePEc:eee:jetheo:v:146:y:2011:i:3:p:1224-1252
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Evans, George W. & Honkapohja, Seppo, 2003. "Policy interaction, expectation and the liquidity trap," Research Discussion Papers 22/2003, Bank of Finland.
  2. Woodford, Michael & Santos, Manuel S., 1995. "Rational asset pricing bubbles," UC3M Working papers. Economics 3913, Universidad Carlos III de Madrid. Departamento de Economía.
  3. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, vol. 71(3), pages 341-345, June.
  4. George W. Evans & Seppo Honkapohja, 2003. "Adaptive learning and monetary policy design," Proceedings, Federal Reserve Bank of Cleveland, pages 1045-1084.
  5. Krisztina Molnar & Sergio Santoro, 2006. "Optimal Monetary Policy when Agents are Learning," Computing in Economics and Finance 2006 40, Society for Computational Economics.
  6. Klaus Adam, 2003. "Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky Prices," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 887-907.
  7. George W. Evans & Seppo Honkapohja, 2001. "Expectations and the Stability Problem for Optimal Monetary Policies," University of Oregon Economics Department Working Papers 2001-6, University of Oregon Economics Department, revised 03 Aug 2001.
  8. Drew Fudenberg & David K. Levine, 1993. "Self-Confirming Equilibrium," Levine's Working Paper Archive 2147, David K. Levine.
  9. Pástor, Luboš & Veronesi, Pietro, 2002. "Stock Valuation and Learning about Profitability," CEPR Discussion Papers 3410, C.E.P.R. Discussion Papers.
  10. Bruce Preston, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," International Journal of Central Banking, International Journal of Central Banking, vol. 1(2), September.
  11. Athanasios Orphanides & John C. Williams, 2002. "Imperfect knowledge, inflation expectations, and monetary policy," Finance and Economics Discussion Series 2002-27, Board of Governors of the Federal Reserve System (U.S.).
  12. Cogley, Timothy & Sargent, Thomas J., 2008. "The market price of risk and the equity premium: A legacy of the Great Depression?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 454-476, April.
  13. Pesaran, M.H. & Pettenuzzo, D. & Timmermann, A., 2006. "Learning, Structural Instability and Present Value Calculations," Cambridge Working Papers in Economics 0602, Faculty of Economics, University of Cambridge.
  14. Albert Marcet & Juan P. Nicolini, 1995. "Recurrent hyperinflations and learning," Economics Working Papers 244, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2001.
  15. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
  16. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
  17. Stefano Eusepi & Bruce Preston, 2011. "Expectations, Learning, and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 101(6), pages 2844-72, October.
  18. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
  19. Adam, Klaus, 2003. "Learning to Forecast and Cyclical Behavior of Output and Inflation," CFS Working Paper Series 2003/01, Center for Financial Studies (CFS).
  20. Michael Woodford, 2010. "Robustly Optimal Monetary Policy with Near-Rational Expectations," American Economic Review, American Economic Association, vol. 100(1), pages 274-303, March.
  21. Klaus Adam & Albert Marcet, 2010. "Booms and Busts in Asset Prices," IMES Discussion Paper Series 10-E-02, Institute for Monetary and Economic Studies, Bank of Japan.
  22. Thomas J Sargent, 2007. "Evolution and Intelligent Design," Levine's Bibliography 122247000000001821, UCLA Department of Economics.
  23. Robert J Aumann, 1999. "Agreeing to Disagree," Levine's Working Paper Archive 512, David K. Levine.
  24. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2006. "Learning and Stock Market Volatility," Computing in Economics and Finance 2006 15, Society for Computational Economics.
  25. Lawrence Blume & David Easley, 2001. "If You're So Smart, Why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Working Papers 01-06-031, Santa Fe Institute.
  26. J. Michael Harrison & David M. Kreps, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, Oxford University Press, vol. 92(2), pages 323-336.
  27. Robert M. Anderson & Hugo Sonnenschein, 1985. "Rational Expectations Equilibrium with Econometric Models," Review of Economic Studies, Oxford University Press, vol. 52(3), pages 359-369.
  28. Allan Timmermann, 1996. "Excess Volatility and Predictability of Stock Prices in Autoregressive Dividend Models with Learning," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 523-557.
  29. Allan G. Timmermann, 1993. "How Learning in Financial Markets Generates Excess Volatility and Predictability in Stock Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 108(4), pages 1135-1145.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eee:jetheo:v:146:y:2011:i:3:p:1224-1252. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Shamier, Wendy)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.