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Money Illusion and Rational Expectations: New Evidence from Well Known Survey Data

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  • Novella Maugeri

Abstract

This paper provides further evidence in favor of less than fully rational expectations by making use two instruments, one quite well known, and the other more novel, namely survey data on inflation expectations and Smooth Transition Error Correction Models (STECMs). We use the so called ‘probabilistic approach’ to derive a quantitative measure of expected inflation from qualitative survey data for France, Italy and the UK. The United States are also included by means of the Michigan Survey of Consumers’ expectations series. First, we perform the standard tests to assess the ‘degree of rationality’ of consumers’ inflation forecasts. Afterwards, we specify a STECM of the forecast error, and we quantify the strategic stickiness in the long-run adjustment process of expectations stemming from money illusion. Our evidence is that consumers’ expectations do not generally conform to the prescriptions of the rational expectations hypothesis. In particular, we find that the adjustment process towards the long-run equilibrium is highly nonlinear and it is asymmetric with respect to the size of the past forecast errors. We interpret these findings as supporting the money illusion hypothesis.

Suggested Citation

  • Novella Maugeri, 2010. "Money Illusion and Rational Expectations: New Evidence from Well Known Survey Data," Department of Economics University of Siena 606, Department of Economics, University of Siena.
  • Handle: RePEc:usi:wpaper:606
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    1. Balcilar, Mehmet & Gupta, Rangan & Shah, Zahra B., 2011. "An in-sample and out-of-sample empirical investigation of the nonlinearity in house prices of South Africa," Economic Modelling, Elsevier, vol. 28(3), pages 891-899, May.
    2. Béreau, Sophie & Villavicencio, Antonia López & Mignon, Valérie, 2010. "Nonlinear adjustment of the real exchange rate towards its equilibrium value: A panel smooth transition error correction modelling," Economic Modelling, Elsevier, vol. 27(1), pages 404-416, January.
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    Cited by:

    1. Novella Maugeri, 2014. "Some Pitfalls in Smooth Transition Models Estimation: A Monte Carlo Study," Computational Economics, Springer;Society for Computational Economics, vol. 44(3), pages 339-378, October.

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    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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