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Signal extraction and the propagation of business cycles

  • Kenneth Kasa

This paper studies a class of models developed by Townsend (1993) and Sargent (1991). These models feature dynamic signal extraction problems in which firms with heterogeneous information draw inferences from endogenously generated time series about the value of common persistent shock. Because the information firms receive is partially determined by the expectations of other firms, each firm must 'forecast the forecasts of others'. Moreover, since it is common knowledge that everyone is in the same situation, there occurs an infinite regress in expectations, in which each firm attempts to forecast the forecasts that other firms make about its own forecast, and so on. Townsend and Sargent develop methods for solving this infinite regress problem, and discuss the possibility that in these models expectations themselves become a source of business cycle propagation. This paper contributes in two ways to the work of Townsend and Sargent. ; This paper contributes in two ways to the work of Townsend and Sargent. First, it solves analytically the fixed point problem posed by the infinite regress in expectations. Having an analytical solution facilitates empirical work. Second, it assesses empirically the potential role of forecast errors as a business cycle propagation mechanism. I find that forecast errors can indeed make a quantitatively significant contribution to the propagation of business cycles.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory with number 95-14.

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Date of creation: 1995
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Handle: RePEc:fip:fedfap:95-14
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  1. Grossman, Sanford J & Weiss, Laurence, 1982. "Heterogeneous Information and the Theory of the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 90(4), pages 699-727, August.
  2. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 873-907, October.
  3. Binder, Michael & Pesaran, M Hashem, 1998. "Decision Making in the Presence of Heterogeneous Information and Social Interactions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1027-52, November.
  4. Taub, Bart, 1989. "Aggregate fluctuations as an information transmission mechanism," Journal of Economic Dynamics and Control, Elsevier, vol. 13(1), pages 113-150, January.
  5. Timothy Cogley & James M. Nason, 1993. "Output dynamics in real business cycle models," Working Papers in Applied Economic Theory 93-10, Federal Reserve Bank of San Francisco.
  6. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  7. Townsend, Robert M, 1978. "Market Anticipations, Rational Expectations, and Bayesian Analysis," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 19(2), pages 481-94, June.
  8. Lars Peter Hansen & Thomas J. Sargent, 1979. "Formulating and estimating dynamic linear rational expectations models," Working Papers 127, Federal Reserve Bank of Minneapolis.
  9. Robert J Aumann, 1999. "Agreeing to Disagree," Levine's Working Paper Archive 512, David K. Levine.
  10. Futia, Carl A, 1981. "Rational Expectations in Stationary Linear Models," Econometrica, Econometric Society, vol. 49(1), pages 171-92, January.
  11. 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.
  12. Townsend, Robert M, 1983. "Forecasting the Forecasts of Others," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 546-88, August.
  13. Lucas, Robert E, Jr, 1975. "An Equilibrium Model of the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 83(6), pages 1113-44, December.
  14. Evans, George, 1985. "Expectational Stability and the Multiple Equilibria Problem in Linear Rational Expectations Models," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1217-33, November.
  15. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
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