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Internal Rationality, Imperfect Market Knowledge and Asset Prices

  • Klaus Adam
  • Albert Marcet

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' 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' market knowledge.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1068.

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Date of creation: Aug 2011
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Handle: RePEc:cep:cepdps:dp1068
Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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  1. Timmermann, Allan, 1996. "Excess Volatility and Predictability of Stock Prices in Autoregressive Dividend Models with Learning," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 523-57, October.
  2. 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.
  3. 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.
  4. Timmermann, Allan G, 1993. "How Learning in Financial Markets Generates Excess Volatility and Predictability in Stock Prices," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 1135-45, November.
  5. Marcet, A. & Nicolini, J.P., 1997. "Recurrent Hyperinflations and Learning," Papers 9721, Centro de Estudios Monetarios Y Financieros-.
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  7. 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.
  8. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  9. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, vol. 71(3), pages 341-345, June.
  10. Drew Fudenberg & David K. Levine, 1993. "Self-Confirming Equilibrium," Levine's Working Paper Archive 2147, David K. Levine.
  11. Manuel S. Santos & Michael Woodford, 1993. "Rational Asset Pricing Bubbles," Working Papers 9304, Centro de Investigacion Economica, ITAM.
  12. Michael Woodford, 2005. "Robustly optimal monetary policy with near-rational expectations," Discussion Papers 0506-13, Columbia University, Department of Economics.
  13. Lubos Pastor & Pietro Veronesi, 2002. "Stock Valuation and Learning about Profitability," NBER Working Papers 8991, National Bureau of Economic Research, Inc.
  14. Anderson, Robert M & Sonnenschein, Hugo, 1985. "Rational Expectations Equilibrium with Econometric Models," Review of Economic Studies, Wiley Blackwell, vol. 52(3), pages 359-69, July.
  15. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
  16. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
  17. Adam, Klaus, 2003. "Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky Prices," CFS Working Paper Series 2003/03, Center for Financial Studies (CFS).
  18. Honkapohja, Seppo & Evans, George W., 2000. "Expectations and the stability problem for optimal monetary policies," Discussion Paper Series 1: Economic Studies 2000,10, Deutsche Bundesbank, Research Centre.
  19. Larry Blume & David Easley, 2001. "If You're So Smart, Why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Cowles Foundation Discussion Papers 1319, Cowles Foundation for Research in Economics, Yale University.
  20. 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.
  21. Stefano Eusepi & Bruce Preston, 2008. "Expectations, Learning and Business Cycle Fluctuations," NBER Working Papers 14181, National Bureau of Economic Research, Inc.
  22. George W. Evans & Seppo Honkapohja, 2003. "Adaptive learning and monetary policy design," Proceedings, Federal Reserve Bank of Cleveland, pages 1045-1084.
  23. Evans, George W. & Honkapohja , Seppo, 2003. "Policy interaction, expectations and the liquidity trap," Research Discussion Papers 22/2003, Bank of Finland.
  24. Adam, Klaus, 2005. "Learning To Forecast And Cyclical Behavior Of Output And Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 9(01), pages 1-27, February.
  25. 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.
  26. Robert J Aumann, 1999. "Agreeing to Disagree," Levine's Working Paper Archive 512, David K. Levine.
  27. Thomas J. Sargent, 2008. "Evolution and Intelligent Design," American Economic Review, American Economic Association, vol. 98(1), pages 5-37, March.
  28. 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.
  29. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2006. "Learning and Stock Market Volatility," Computing in Economics and Finance 2006 15, Society for Computational Economics.
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