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Inferential Expectations

  • Gordon D. Menzies

    ()

  • Daniel John Zizzo

We propose that the formation of beliefs be treated as statistical hypothesis tests, and we label such beliefs inferential expectations. If a belief is overturned through the build-up of evidence, agents are assumed to switch to the rational expectation. Rational expectations are shown to be a special (limiting) case of inferential expectations, with the test size alpha becoming a metric for rationality. We present the results of an experiment that supports inferential expectations. When inferential expectations are built into a Dornbusch-style model of the exchange rate, regression tests of Uncovered Interest Parity and the rational expectations version of the term structure both display downward bias in the slope coefficient.

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Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2005-12.

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Length: 42 pages
Date of creation: Jun 2005
Date of revision:
Handle: RePEc:een:camaaa:2005-12
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  1. Gruen, David W R & Menzies, Gordon D, 1995. "Forward Discount Bias: Is It Near-Rationality in the Foreign Exchange Market?," The Economic Record, The Economic Society of Australia, vol. 71(213), pages 157-66, June.
  2. Gordon Menzies & Daniel John Zizzo, 2005. "Inferential Expectations," Research Paper Series 159, Quantitative Finance Research Centre, University of Technology, Sydney.
  3. Akerlof, George A., 2001. "Behavioral Macroeconomics and Macroeconomic Behavior," Nobel Prize in Economics documents 2001-4, Nobel Prize Committee.
  4. Frankel, Jeff & Froot, Ken, 1986. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," Department of Economics, Working Paper Series qt1972q8wm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
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  6. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  7. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  8. Schmalensee, Richard, 1976. "An Experimental Study of Expectation Formation," Econometrica, Econometric Society, vol. 44(1), pages 17-41, January.
  9. Stefan Gerlach & Frank Smets, 1995. "The term structure of Euro-rates: some evidence in support of the expectations hypothesis," BIS Working Papers 28, Bank for International Settlements.
  10. Peyton Young, 2002. "Learning Hypothesis Testing and Nash Equilibrium," Economics Working Paper Archive 474, The Johns Hopkins University,Department of Economics.
  11. Goldberg, Michael D & Frydman, Roman, 1996. "Imperfect Knowledge and Behaviour in the Foreign Exchange Market," Economic Journal, Royal Economic Society, vol. 106(437), pages 869-93, July.
  12. Clemens J. M. Kool & Daniel L. Thornton, 2003. "A note on the expectations hypothesis at the founding of the Fed," Working Papers 2000-004, Federal Reserve Bank of St. Louis.
  13. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information Versus Sticky Prices: A Proposal To Replace The New Keynesian Phillips Curve," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1295-1328, November.
  14. Rotheli, Tobias F., 1998. "Pattern recognition and procedurally rational expectations," Journal of Economic Behavior & Organization, Elsevier, vol. 37(1), pages 71-90, September.
  15. Swenson, Charles W., 1997. "Rational expectations and tax policy: Experimental market evidence," Journal of Economic Behavior & Organization, Elsevier, vol. 32(3), pages 433-455, March.
  16. Bossaerts, Peter & Bodarenko, Oleg, 1997. "Expectations and Learning in Iowa," Working Papers 989, California Institute of Technology, Division of the Humanities and Social Sciences.
  17. Dwyer, Gerald P, Jr, et al, 1993. "Tests of Rational Expectations in a Stark Setting," Economic Journal, Royal Economic Society, vol. 103(418), pages 586-601, May.
  18. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
  19. Mankiw, N Gregory & Miron, Jeffrey A, 1986. "The Changing Behavior of the Term Structure of Interest Rates," The Quarterly Journal of Economics, MIT Press, vol. 101(2), pages 211-28, May.
  20. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information: A Model of Monetary Nonneutrality and Structural Slumps," Harvard Institute of Economic Research Working Papers 1941, Harvard - Institute of Economic Research.
  21. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
  22. Michael Woodford, 1994. "Structural Slumps," Journal of Economic Literature, American Economic Association, vol. 32(4), pages 1784-1815, December.
  23. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  24. Steven Radelet & Jeffrey Sachs, 1998. "The Onset of the East Asian Financial Crisis," NBER Working Papers 6680, National Bureau of Economic Research, Inc.
  25. Beckman, Steven R. & Downs, David, 1997. "Forecasters as imperfect information processors: Experimental and survey evidence," Journal of Economic Behavior & Organization, Elsevier, vol. 32(1), pages 89-100, January.
  26. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729 Elsevier.
  27. Maddock, Rodney & Carter, Michael, 1982. "A Child's Guide to Rational Expectations," Journal of Economic Literature, American Economic Association, vol. 20(1), pages 39-51, March.
  28. Michael Woodford, 1990. "Self-Fulfilling Expectations and Fluctuations in Aggregate Demand," NBER Working Papers 3361, National Bureau of Economic Research, Inc.
  29. Zellner, Arnold, 1988. "Bayesian analysis in econometrics," Journal of Econometrics, Elsevier, vol. 37(1), pages 27-50, January.
  30. Rappoport, Peter, 1985. "Unfalsified Expectations: An Alternative Perspective on Modelling Expectations in Macroeconomics," Working Papers 85-16, C.V. Starr Center for Applied Economics, New York University.
  31. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-20, September.
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