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Near-rational exuberance

  • Bullard, James
  • Evans, George W.
  • Honkapohja, Seppo

We study how the use of judgement or “add-factors” in macroeconomic forecasting may disturb the set of equilibrium outcomes when agents learn using recursive methods. We isolate conditions under which new phenomena, which we call exuberance equilibria, can exist in standard macroeconomic environments. Examples include a simple asset pricing model and the New Keynesian monetary policy framework. Inclusion of judgement in forecasts can lead to self-fulfilling fluctuations, but without the requirement that the underlying rational expectations equilibrium is locally indeterminate. We suggest ways in which policymakers might avoid unintended outcomes by adjusting policy to minimize the risk of exuberance equilibria. JEL Classification: E52, E61

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Paper provided by European Central Bank in its series Working Paper Series with number 0555.

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Date of creation: Nov 2005
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Handle: RePEc:ecb:ecbwps:20050555
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  1. Roger Lagunoff & Stacey L. Schreft, 1999. "Financial Fragility with Rational and Irrational Exuberance," Macroeconomics 9904011, EconWPA.
  2. George W. Evans & Seppo Honkapohja, 2003. "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 807-824, October.
  3. Thomas Sargent & Noah Williams & Tao Zha, 2006. "The conquest of South American inflation," Working Paper 2006-20, Federal Reserve Bank of Atlanta.
  4. Svensson, Lars E. O., 2005. "Monetary policy with judgment: forecast targeting," Working Paper Series 0476, European Central Bank.
  5. George W. Evans & Seppo Honkapohja, . "Economic Dynamics with Learning: New Stability Results," Computing in Economics and Finance 1997 51, Society for Computational Economics.
  6. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  7. Evans, George W. & Honkapohja, Seppo & Honkapohja, Seppo, 1994. "Learning, convergence, and stability with multiple rational expectations equilibria," European Economic Review, Elsevier, vol. 38(5), pages 1071-1098, May.
  8. Hommes, Cars & Sorger, Gerhard, 1998. "Consistent Expectations Equilibria," Macroeconomic Dynamics, Cambridge University Press, vol. 2(03), pages 287-321, September.
  9. Lars E.O. Svensson & Robert J. Tetlow, 2005. "Optimal Policy Projections," International Journal of Central Banking, International Journal of Central Banking, vol. 1(3), December.
  10. George W. Evans & Seppo Honkapohja, 2004. "Adaptive learning and monetary policy design," Macroeconomics 0405008, EconWPA.
  11. 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.
  12. 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.
  13. repec:cup:macdyn:v:2:y:1998:i:3:p:287-321 is not listed on IDEAS
  14. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
  15. Reifschneider, David L. & Stockton, David J. & Wilcox, David W., 1997. "Econometric models and the monetary policy process," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 1-37, December.
  16. Evans, George W. & Honkapohja, Seppo, 1999. "Learning dynamics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 7, pages 449-542 Elsevier.
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