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Inferential Expectations

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 a becoming a metric for rationality. 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. We present the results of an experiment that supports inferential expectations.

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File URL: http://www.qfrc.uts.edu.au/research/research_papers/rp159.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 159.

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Length: 41 pages
Date of creation: 01 May 2005
Publication status: Published as: Menzies, G. and Zizzo, J., 2009, "Inferential Expectations", The B.E. Journal of Macroeconomics, 9(1), 1-27.
Handle: RePEc:uts:rpaper:159
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