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The rationality of expectations formation and excess volatility

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Abstract

I establish, in simple deterministic overlapping generations economies, that if each agent holds rationally formed expectations in the sense that any other expectations justifying his choices imply a smaller likelihood for the history he observes with limited memory, then there are rationally formed expectations equilibria exhibiting an excess volatility that no rational expectations equilibrium can match. Given that the limited records or finite memory case may arguably be the relevant one from a positive viewpoint, this result suggests that the possibility of excess volatility as an equilibrium phenomenon has been downplayed by the use of the rational expectations hypothesis.

Suggested Citation

  • Julio Dávila, 2008. "The rationality of expectations formation and excess volatility," Documents de travail du Centre d'Economie de la Sorbonne b08019, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
  • Handle: RePEc:mse:cesdoc:b08019
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    Keywords

    Expectations; rationality; volatility.;

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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