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Internal Rationality and Asset Prices

  • Adam, Klaus
  • Marcet, Albert

We present a decision theoretic framework with agents that are learning about the behavior of market determined variables. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given consistent beliefs about the future, but may not be 'externally rational', i.e., may not know the true stochastic process for market determined variables (asset prices) and fundamentals (dividends). We apply this approach to a simple asset pricing model with heterogeneity and incomplete markets. We show how knowledge about dividends and optimal behavior alone fail to fully inform agents about equilibrium prices, so that learning about price behavior, as in Adam, Marcet and Nicolini (2008), is fully consistent with internal rationality. We also show that equilibrium prices depend on expectations of the discounted price and dividend in the next period only, rather than on the expected discounted sum of future dividends. Discounted sums emerge only after making very strong assumptions about agents' knowledge and prove extremely sensitive to the details about agents' prior beliefs about the dividend process.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7498.

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Date of creation: Oct 2009
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Handle: RePEc:cpr:ceprdp:7498
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  1. Stefano Eusepi & Bruce Preston, 2008. "Expectations, Learning And Business Cycle Fluctuations," CAMA Working Papers 2008-20, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  2. Krisztina Molnár & Sergio Santoro, 2006. "Optimal Monetary Policy When Agents Are Learning," IEHAS Discussion Papers 0601, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences, revised 15 Mar 2006.
  3. Adam, Klaus, 2003. "Learning to Forecast and Cyclical Behavior of Output and Inflation," CFS Working Paper Series 2003/01, Center for Financial Studies (CFS).
  4. Hashem Pesaran & Davide Pettenuzzo & Allan Timmermann, 2007. "Learning, Structural Instability, and Present Value Calculations," Econometric Reviews, Taylor & Francis Journals, vol. 26(2-4), pages 253-288.
  5. 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.
  6. Bruce Preston, 2003. "Learning about monetary policy rules when long-horizon expectations matter," Working Paper 2003-18, Federal Reserve Bank of Atlanta.
  7. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2006. "Learning and Stock Market Volatility," Computing in Economics and Finance 2006 15, Society for Computational Economics.
  8. repec:acb:camaaa:2008-20 is not listed on IDEAS
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