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Macroeconomics with Learning and Misspecification: A General Theory and Applications

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  • Pooya Molavi

    (Massachusetts Institute of Technology)

Abstract

This paper explores a form of bounded rationality where agents learn about the economy with possibly misspecified models. I consider a recursive general-equilibrium framework that nests a large class of macroeconomic models. Misspecification is represented as a constraint on the set of beliefs agents can entertain. I introduce the solution concept of constrained-rational expectations equilibrium (CREE), in which each agent selects the belief from her constrained set that is closest to the endogenous distribution of observables in the Kullback–Leibler divergence. If the set of permissible beliefs contains the rational-expectations equilibria (REE), then the REE are CREE; otherwise, they are not. I show that a CREE exists, that it arises naturally as the limit of adaptive and Bayesian learning, and that it incorporates a version of the Lucas critique. I then apply CREE to a particular novel form of bounded rationality where beliefs are constrained to factor models with a small number of endogenously chosen factors. Misspecification leads to amplification or dampening of shocks and history dependence. The calibrated economy exhibits hump-shaped impulse responses and co-movements in consumption, output, hours, and investment that resemble business-cycle fluctuations.

Suggested Citation

  • Pooya Molavi, 2019. "Macroeconomics with Learning and Misspecification: A General Theory and Applications," 2019 Meeting Papers 1584, Society for Economic Dynamics.
  • Handle: RePEc:red:sed019:1584
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    File URL: https://economicdynamics.org/meetpapers/2019/paper_1584.pdf
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    References listed on IDEAS

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    6. 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, Oxford University Press, vol. 117(4), pages 1295-1328.
    7. Erik Eyster & Kristof Madarasz & Pascal Michaillat, 2017. "Pricing when Customers Care about Fairness but Misinfer Markups," NBER Working Papers 23778, National Bureau of Economic Research, Inc.
    8. Erik Eyster & Michele Piccione, 2013. "An Approach to Asset Pricing Under Incomplete and Diverse Perceptions," Econometrica, Econometric Society, vol. 81(4), pages 1483-1506, July.
    9. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
    10. Sargent, Thomas J., 1993. "Bounded Rationality in Macroeconomics: The Arne Ryde Memorial Lectures," OUP Catalogue, Oxford University Press, number 9780198288695.
    11. Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2006. "Ambiguity Aversion, Robustness, and the Variational Representation of Preferences," Econometrica, Econometric Society, vol. 74(6), pages 1447-1498, November.
    12. Alexander Zimper & Wei Ma, 2017. "Bayesian learning with multiple priors and nonvanishing ambiguity," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 64(3), pages 409-447, October.
    13. repec:eee:macchp:v2-415 is not listed on IDEAS
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