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Misperceptions, heterogeneous expectations and macroeconomic dynamics

  • Harrison, Richard

    ()

    (Bank of England)

  • Taylor, Tim

    ()

    (Bank of England)

We investigate the extent to which misperceptions about the economy can become self-reinforcing and thereby contribute to time-varying macroeconomic dynamics. To do so, we build a New Keynesian model with long-horizon expectations and dynamic predictor selection. Because agents solve multi-period optimisation problems (households maximise expected lifetime utility and firms maximise the discounted flow of future profits), their current decisions are influenced by expectations of the distant future and cannot in general be characterised by the familiar Euler equations that represent the rational expectations equilibrium of these models. We assume that agents have access to a set of alternative predictors that can be used to form expectations and choose among them based on noisy measures of their recent performance. This dynamic predictor selection generates endogenous fluctuations in the proportions of agents using each predictor, contributing to macroeconomic dynamics. We explore the behaviour of our model when agents have access to two simple predictors. One of the predictors is consistent with a mistaken belief that macroeconomic variables are more persistent than implied by the fundamental shocks hitting the economy. We show that the presence of a ‘persistent predictor’ can lead to changes in beliefs which are self-reinforcing, giving rise to endogenous fluctuations in the time-series properties of the economy. Moreover, we show that such fluctuations arise even if we replace the ‘persistent predictor’ with learning under constant gain.

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Paper provided by Bank of England in its series Bank of England working papers with number 449.

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Length: 41 pages
Date of creation: 18 May 2012
Date of revision:
Handle: RePEc:boe:boeewp:0449
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  1. Carceles-Poveda, Eva & Giannitsarou, Chryssi, 2007. "Adaptive learning in practice," Journal of Economic Dynamics and Control, Elsevier, vol. 31(8), pages 2659-2697, August.
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  3. Fabio Milani, 2006. "A Bayesian DSGE Model with Infinite-Horizon Learning: Do "Mechanical" Sources of Persistence Become Superfluous?," International Journal of Central Banking, International Journal of Central Banking, vol. 2(3), September.
  4. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
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  9. Harrison, Richard & Taylor, Tim, 2012. "Non-rational expectations and the transmission mechanism," Bank of England working papers 448, Bank of England.
  10. Sargent, Thomas J., 1991. "Equilibrium with signal extraction from endogenous variables," Journal of Economic Dynamics and Control, Elsevier, vol. 15(2), pages 245-273, April.
  11. Anufriev, M. & Hommes, C.H., 2007. "Evolution of Market Heuristics," CeNDEF Working Papers 07-06, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  12. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  13. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers 9530r, Wisconsin Madison - Social Systems.
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  15. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
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