International Research Forum on Monetary Policy: Screen Reader version ^{♣}

Some Evidence from the Lab *

CeNDEF, School of Economics, University of Amsterdam,

Roetersstraat 11, NL-1018 WB Amsterdam, Netherlands

Roetersstraat 11, NL-1018 WB Amsterdam, Netherlands

Keywords: Heterogeneous Expectations, bounded rationality, learning, heuristics switching.

Abstract:

This paper surveys learning to forecast experiments (LtFEs) with human subjects to test theories of expectations and learning. Subjects must repeatedly forecast a market price, whose realization is an aggregation of individual forecasts. Emphasis is given to how individual forecasting rules
interact at the micro level and which structure they co-create at the aggregate, macro level. In particular, we focus on the question wether the evidence from laboratory experiments is consistent with heterogeneous expectations.

*"Recent theoretical work is making it increasingly clear that the multiplicity of equilibria ... can arise in a wide variety of situations involving sequential trading, in competitive as well as finite-agent games. All but a few of these equilibria are, I believe, behaviorally uninteresting:
They do not describe behavior that collections of adaptively behaving people would ever hit on. I think an appropriate stability theory can be useful in weeding out these uninteresting equilibria ... But to be useful, stability theory must be more than simply a fancy way of saying that one does not
want to think about certain equilibria. I prefer to view it as an experimentally testable hypothesis, as a special instance of the adaptive laws that we believe govern all human behavior"* (Lucas, 1986, pp. S424-425).

1 Introduction

Individual expectations about future aggregate outcomes is the key feature that distinguishes social sciences and economics from the natural sciences. Daily weather forecasts, either by the public or by experts, do not affect the probability of rain. In contrast, overly optimistic expectations about the economic outlook may have exaggerated the strong rise in world wide financial markets in the late 1990s and, more recently, the excessive growth in housing prices in 2000-2008, while an overly pessimistic outlook by the public and by economists may have amplified the recent financial crisis and deepened the current economic crisis.

Economic decisions today thus depend upon expectations about the future state of the economy. A theory of individual expectations or market beliefs is therefore a crucial part of economic theory. The market is an expectations feedback system and any dynamic economic model depends crucially upon
its underlying *expectations hypothesis*. But how then should one model individuals who learn from the past and adapt their behavior as more and more market realizations become available over time?

Since the seminal works of Muth (1961) and Lucas (1972), the Rational Expectations Hypothesis (REH) has become the leading paradigm on expectation formation in economics, and rational expectations representative agent models have become the mainstream tool of analysis. In such a framework, all
agents are the same and forecast rationally, using all available information. Rational expectations are by assumption *model consistent* and coincide on average with realizations, without systematic forecasting errors. The rational expectations (RE) approach has important advantages: it is
simple, elegant and puts strong discipline on individual (forecasting) behavior minimizing the number of free parameters. But drawbacks of the rational agent paradigm are also well known: it is unrealistic in assuming perfect knowledge about the economy (typically it assumes knowledge of the law of
motion of the economy) and, even if such knowledge were known, RE requires extremely strong computing abilities of the agents to compute the equilibrium. Most importantly, RE models are at odds with empirical observations and behavior in laboratory experiments wit human subjects and, for example,
the decline of worldwide financial markets by almost 50% between October 2008 and March 2009 is hard to reconcile with rational behavior.

Economics, or at least a significant part of it, is currently witnessing a paradigm shift to an alternative, behavioral view, where agents are *boundedly rational*. This alternative view dates back to Simon (1957) and contains many elements from psychology, e.g. through the work of Tversky
and Kahnemann (1974). The need for a new paradigm in economics has recently been forcefully advocated by Akerlof and Shiller (2009), Colander et al. (2009) and DeGrauwe (2009). Concerning expectations of boundedly rational agents, an alternative theory of *adaptive learning* has been
developed, see e.g. Sargent (1993) for an early and Evans and Honkapohja (2001) for a more detailed overview. Boundedly rational agents do not know the law of motion of the economy, but instead use time series observations to form expectations and adapt their behavior trying to learn model
parameters of their perceived law of motion as more observations become available. Adaptive learning sometimes enforces convergence to REE, but it may also lead to non-RE equilibria, such as the learning equilibria in Bullard (1994). Adaptive learning models are sometimes "cautious modifications
of rational expectations theories" (Sargent, 2008, p26) and other times large deviations from rationality explaining excess volatility through expectations driven fluctuations (Grandmont, 1998). Bounded rationality however also has important drawbacks. In particular, the `wilderness" of bounded
rationality (Sims, 1980) leads to (too) many degrees of freedom and too many free parameters. There are simply too many ways of modeling non-rational behavior. This "wilderness" of bounded rationality, seems particularly relevant when individuals have *heterogeneous expectations*.

A rough estimate indicates that in the past 20 years more than 1000 papers on *bounded rationality* and *learning* have appeared. Among these, in the last decade hundreds of (theoretical) papers on agent-based models populated with boundedly rational agents employing
*heterogeneous* strategies/expectations have appeared, especially with applications in finance; see the comprehensive surveys of LeBaron (2006) and Hommes (2006) in the *Handbook of Computational Economics* *Volume 2: Agent-Based Computational Economics (Tesfatsion and Judd, 2006*
and very recent surveys by Hommes and Wagener (2009) and Chiarella et al. (2009) in the *Handbook of Financial Markets: Dynamics and Evolution* (Hens and Schenk-Hoppé, 2009) as well as papers and references in the *Handbook of Economic Complexity* (Rosser, 2009)^{1}. Most of these papers present stylized, theoretical models or larger, agent-based simulation models, with the realistic feature that these models can mimic many
*stylized facts* in financial time series (Lux, 2009) and in macro data (Delli-Gatti et al., 2008).

The empirical validation of heterogeneity is an important area of current research. For example, Baak (1999) and Chavas (2000) estimate heterogeneous agent models (HAMs) on hog and beef market data, and found empirical evidence for heterogeneity of expectations. For the beef market Chavas (2000) estimates that about 47% of the beef producers behave naively (using only the last price in their forecast), 18% of the beef producers behaves rationally, whereas 35% behaves quasi-rationally (i.e. use a univariate autoregressive time series model to forecast prices). A number of recent contributions have estimated heterogeneous agent models with fundamentalists and chartist strategies on stock prices (e.g. Boswijk et al. (2007), de Jong, Verschoor and Zwinkels (2009), exchange rates (e.g. Gilli and Winker (2003), Westerhoff and Reitz (2003) and several commodities (e.g. gold prices (Alfarano et al., 2005), and oil prices (ter Ellen and Zwinkels, 2009)). Most of these studies find significant time-variation in the fractions of agents using a mean-reverting fundamental versus a trend-following strategy. Empirical evidence for heterogeneous trading strategies in the Spanish Stock Market Exchange has been found in Vaglica et al. (2008); in particular, Lillo et al. (2008) show that the investors can be classified in different groups, including trend followers and contrarians, whose change of inventory of the stock is positively respectively negatively correlated with stock return.

A related, complementary branch of empirical literature uses *survey data* to measure individual expectations; see Pesaran and Weale (2006) for a stimulating overview. An advantage of survey data analysis is that it can focus exclusively on the expectations-generating process, avoiding the
dilemma of testing joint hypotheses. There is quite some evidence on forecasting heterogeneity in survey data. For example, Frankel and Froot (1987, 1990), Allen and Taylor (1990) and Taylor and Allen (1992) already found that financial experts use different forecasting strategies to predict
exchange rates. They tend to use trend extrapolating rules at short horizons (up to 3 months) and mean-reverting fundamentalists rules at longer horizons (6 months to 1 year) and, moreover, the weight given to different forecasting techniques changes over time. Vissing-Jorgensen (2003) presents
evidence of heterogeneous beliefs of individual investors about the prospect of the stock market, while Shiller (2000) finds evidence that investor's sentiment changes over time, with both institutions and individual investors becoming more optimistic in response to recent significant increases of
the stock market. Evidence concerning heterogeneity in survey data on exchange rate expectations can also be found in MacDonald and Marsh (1996), Elliott and Ito (1999), Prat and Uctum (2000) and Bénassy-Quéré et al. (2003). Dreger and Stadtmann (2008) show that for exchange
rate forecasts at a 6 months horizon, different expectations about macroeconomic fundamentals is what drives heterogeneity. Mankiw et al. (2003) find evidence for heterogeneity in inflation expectations in the Michigan Survey of Consumers and show that the data are inconsistent with either rational
or adaptive expectations, but may be consistent with a sticky information model. Capistrán and Timmermann (2009) show that heterogeneity of inflation expectations of professional forecasters varies systematically over time, and depends on the level and the variance of current inflation.
Pfajfar and Santoro (2009) measure the degree of heterogeneity in private agents' inflation forecasts by exploring time series of percentiles from the empirical distribution of survey data. They show that heterogeneity in inflation expectations is pervasive and identify three regions of the
distribution corresponding to different expectations formation mechanisms: a static or highly autoregressive region on the left hand side of the median, a nearly rational region around the median and a fraction of forecasts on the right hand side of the median consistent with adaptive learning and
sticky information. Branch (2004, 2007) estimates a simple switching model with heterogeneous expectations, along the lines of Brock and Hommes (1997), and provides empirical evidence suggesting that models which allow the degree of heterogeneity to change over time provide a better fit on exchange
rate survey data.

In this paper, we discuss laboratory experiments with human subjects that can be used to validate expectations hypotheses and learning models. Lucas (1986) already stressed the importance of laboratory experiments in studying adaptive learning and its stability (see the quote at the beginning).
In particular, we are interested in the potential role of heterogeneity in expectations. We quote from Muth (1961, p.321, emphasis added) on expectations heterogeneity and its aggregate effect: *"Allowing for cross-sectional differences in expectations is a simple
matter, because their* aggregate affect is negligible

In this paper we discuss *learning to forecast experiments* (LtFEs) which provide a controlled laboratory environment to study individual expectations as well as aggregate outcomes, and investigate questions such as:

- How do individuals form expectations and how do they
and

bf learn*adapt*their behaviour? - How do individual forecasting rules
*interact*at the*micro*level and which*aggregate outcome*do they co-create at the*macro*level ? - Will
*coordination*occur, even when there is limited information, or will*heterogeneity*persist? - When does
*learning*enforce convergence to REE and when do "learning equilibria" arise?

The goals of this paper are twofold. Firstly, we summarize a number of LtFEs in different market environments. Secondly, we fit a theory of heterogeneous expectations to the experimental data and discuss how well the model explains the data across different market settings. This poses a particular challenge: is there a general, perhaps even a universal theory of heterogeneous expectations, that is, can one come up with one single expectations hypothesis explaining all LtFEs across different market settings?

The paper is organized as follows. Section 2 summarizes related literature on experiments on expectations. Section 3 discusses an experiment in a cobweb market modeling framework, while Section 4 describes an asset pricing experiment. Section 5 presents a simple forecasting heuristics switching
model, where agents switch between different forecasting rules based upon their recent performance, and fits the model to the asset pricing experiments. In Section 6 the same switching model is fitted to experimental data in different market settings, where the *only* difference comes from the
type of expectations feedback, positive versus negative. Section 7 briefly discusses some recent experiments in a New Keynesian macro setting and Section 8 concludes.

2 Learning-to-forecast experiments (LtFEs)

Laboratory experiments with human subjects, with full control over the market environment and economic fundamentals, form an ideal tool to study interactions at the micro-level and how individual behavior affects aggregate market outcomes. Duffy (2008ab) provides stimulating and up to date surveys of "experimental macroeconomics". Early work in this area focussed on market mechanisms, such as double auctions, and the availability of information and futures markets, ensuring that equilibrium will be reached (e.g. Smith (1962), Plott ad Sunder (1982), Sunder (1995) and Plott and Smith (20xx)). More recently, unstable market environments where equilibrium may not be reached, but instead bubbles and crashes may arise have also been designed (e.g. Smith et al. (1988) and Lei et al. (2001).

In experimental work expectations often plays an indirect or implicit role. However, in order to avoid joint hypothesis testing there is an expanding literature on exclusive experimental testing of the expectations hypothesis. An early example is Schmalensee (1976), who presents subjects with
historical data on wheat prices and asks them to predict the mean wheat price for the next 5 periods. Williams (1987) considers expectation formation in an experimental double auction market,
which varies from period to period by small shifts in the market clearing price. Participants predict the mean contract price for 4 or 5 consecutive periods and the participant with the lowest forecast error earns $1.00. In Dwyer et al. (1993) and Hey (1994) subjects have to predict a time series generated by an (exogenous) stochastic process such as a random walk or a simple
linear first order autoregressive process. Kelley and Friedman (2002) consider learning in an Orange Juice Futures price forecasting experiment, where prices are driven by a linear stochastic process with two exogenous variables (weather and competing supply). But in these papers there is no
expectations feedback, since market realizations are *not* affected by individual forecasts.

Here, we focus on so-called *learning-to-forecast experiments* (LtFEs), where subject's *only* task is to forecast the price of some commodity for a number, say 50-60, periods, with the realized market price in each period determined by (average) individual expectations. In LtFEs
subjects' forecasting decisions are thus separated from market-trading decisions. The subjects in the experiments do not participate themselves directly in other market activities, such as trading or producing, but are forecasters (e.g. advisors to large producers or financial investors) whose
earnings increase when forecasting errors decrease. At the beginning of each period, individual forecasts are collected, which feed directly into (unknown) demand and/or supply functions and computerized trading yields a market price, derived from equilibrium between aggregate demand and supply,
that becomes available to the subjects at the end of the period. Demand and supply curves are derived from maximization of expected utility, profit or wealth and thus consistent with rational optimizing behavior.

These LtFEs were motivated by the bounded rationality literature, in order to distinguish between different theories of expectations and learning. Sargent (1993), for example, emphasizes two different requirements of rational expectations. The first requirement imposes that individuals maximize an objective function (utility, profit, wealth, etc.) subject to perceived constraints, while the second requirement imposes mutual consistency of these perceptions. Marimon and Sunder (1994) were the first to set up experiments testing individual rationality and mutual consistency either jointly or separately and used different experimental designs to distinguish between "learning-to-optimize" versus "learning-to-forecast" experiments (Marimon and Sunder, 1994, p.134). The LtFEs focus exclusively on the role of expectations, using computerized optimal individual demand and supply schedules once these individual forecasts have been made.

In LtFEs, subjects typically only have *qualitative* information about the market. They know that the price is an aggregation of individual forecasts, derived from equilibrium
between demand and supply and are able to infer the type of expectations feedback, *positive* or *negative*. Positive (negative) feedback means that an increase of (average) individual forecasts leads to a higher (lower) market equilibrium price. Positive feedback is important in
speculative asset markets, where higher market expectations lead to an increase of speculative demand and therefore an increase of the realized asset price. Negative feedback may be dominant in supply driven commodity markets, where an increase in expected prices leads to higher production and thus
to a lower realized market price. Subjects in the LtFEs know past prices and their own past forecasts and earnings, typically in table as well as in graphic form, as illustrated by an example in Figure 1. They do however *not* know the forecasts of other
participants, the exact market equilibrium equation, the exact demand and supply schedules and the exact number of other demanders and/or suppliers in the market. The type of information in the experiment is thus very similar to models of bounded rationality and adaptive learning, were agents try
to learn a perceived law of motion, based upon time series observations without knowing the underlying actual law of motion of the market.

Quite a number of LtFEs have appeared in the literature. In a series of papers, Marimon, Spear and Sunder studied expectation formation in inflationary overlapping generations economies. Marimon, Spear and Sunder (1993) find experimental evidence for expectationally driven cycles and coordination of beliefs on a sunspot 2-cycle equilibrium, but only after agents have been exposed to exogenous shocks of a similar kind. Marimon and Sunder (1995) present experimental evidence that a "simple" rule, such as a constant growth of the money supply, can help coordinate agents' beliefs and help stabilize the economy. More recently, a number of LtFEs within other macro economic frameworks have been performed. Adam (2007) uses a simple model of sticky prices and shows that a restricted perception equilibrium explains the experimental data better than the RE benchmark solution. Pfajfar and Santoro (2009) and Assenza et al. (2009) run LtFEs in a new Keynesian framework. Pfajfar and Santoro (2009) find evidence for heterogeneity of expectations in their experimental data and three different types of forecasting rules: simple heuristics (e.g. trend following rules), adaptive learning and rational expectations. The LtFEs of Assenza et al. (2009) will be briefly discussed in Section 7.

A learning to forecast experiment may be seen as a test bed for the expectations hypothesis in a benchmark model, assuming that all other assumptions such as rational, utility and profit maximizing behavior are satisfied. A learning to forecast experiment thus provides *clean data* on
*individual expectations* as well as *aggregate price behavior*. Here we will discuss learning to forecast experiments, based on three benchmark models: (1) the cobweb model, (2) a standard asset pricing model and (3) a New Keynesian macro model. The underlying laws of motion are of the
form

In the cobweb LtFE experiments in Hommes al. (2007), the realized market price in (2.1) is a (nonlinear) function of all individual one-period ahead forecasts . In the asset pricing LtFE in Hommes et al. (2005a, 2008) the realized market price in (2.2) is a (nonlinear) function of all two-period ahead individual forecasts of next periods price . There is another important difference between the cobweb and the asset pricing LtFEs: negative versus positive expectations feedback. Positive feedback means that the realized market price increases, when an individual price forecast increases. This feature is characteristic of speculative asset markets, where an increase of the price forecast leads to higher demand for the asset and therefore to higher market prices; mathematically it means that the map in (2.2) is an increasing function of individual forecasts. Negative feedback prevails in supply driven markets, where a higher expected price leads to increased production and thus a lower realized market price; the map in (2.1) underlying the cobweb experiments is decreasing in individual forecasts. In Section 6 we review the LtFE of Heemeijer et al. (2009), comparing positive versus negative feedback systems. Despite the fact that the

Finally, in the New Keynesian macro model expectations on two different variables interact and realized inflation and realized output gap in (2.3) simultaneously depend (linearly) on all two-period ahead individual forecasts of both inflation and the output gap. In Section 7 we will briefly discuss the LtFE of Assenza et al. (2009), where the dynamics of inflation and the output gap is driven simultaneously by individual expectations of both inflation and the output gap.

3 Cobweb Experiments

In this section we discuss LtFE in the classical cobweb framework. This is exactly the same framework employed in the seminal paper of Muth (1961) introducing rational expectations. These cobweb LtFEs may thus be seen as a direct test of the REH in the cobweb model, assuming all other modeling assumptions (e.g. producers' profit maximization and consumers utility maximization) are satisfied. Carlson (1967) already conducted hand-run experiments with subjects as cobweb suppliers. Holt and Villamil (1986) and Hommes et al. (2000) conducted individual cobweb experiments, where price fluctuations are induced by decisions of a single individual. Wellford (1989) conducted several computerized cobweb experiments, where market prices were determined by subjects’ quantity decisions.

Here we focus on the LtFEs in Hommes et al. (2007) with participants per session. The participants were asked to predict next period's price of a commodity under limited information on
the structural characteristics of the market. Participants were only informed about the basic principles of the cobweb-type market. They were advisors to producers, whose only job is to accurately forecast the price of the good for 50 subsequent periods. Pay-offs were defined as a quadratic
function of squared forecasting errors, truncated at 0:^{2}

Participants were informed that the price would be determined by market clearing and that it would have to be within the range . Furthermore, they knew that there was (negative) feedback from individual price forecasts to realized market price in the sense that if their forecast would increase, the supply would increase and consequently the market clearing price would decrease. Subjects however did not know how large these feedback effects would be, as they had no knowledge of underlying market equilibrium equations. Subjects thus had

The realized price in the experiments was determined by the (unknown) market equilibrium between demand and supply:

(3.2) |

with the price forecast of participant at time . Demand was exogenously given by a simple linear schedule:

(3.3) |

with a small stochastic shock drawn from a Normal distribution representing small random demand fluctuations. Supply was determined by the nonlinear schedule

tanh | (3.4) |

This increasing, nonlinear supply schedule can be derived from producer's expected profit maximization with a convex cost function. Subjects in the experiment thus do not participate themselves in production decisions, but supply is computed as if each individual producer maximizes expected profit, given his/her individual price forecast. The parameter tunes the nonlinearity of the supply curve and the stability of the underlying cobweb model. The resulting equilibrium price is obtained as:

(3.5) |

where . Given the parameters and the aggregate realized price depends on individual price expectations as well as the realization of the (small) stochastic shocks. While the parameters of the demand function and the realizations of the noise component remained unchanged across all treatments at , and , the slope parameter of the supply function was varied. Here we consider two treatments. A stable treatment had , for which under naive expectations the price converges quickly to the rational expectations equilibrium. In another strongly unstable treatment, with , under naive expectations the RE price is unstable and prices converge to a 2-cycle, as illustrated in Fig. 2. Along the 2-cycle producers are "irrational" in the sense that they make systematic forecasting errors, predicting a high (low) price when realized market price will be low (high).

Under rational expectations, all individuals would predict the unique price , at which demand and supply intersect. Given that all individuals have rational expectations, realized prices will be given by

that is, small random fluctuations around the RE steady state. Given the limited market information one can not expect that all individuals have rational expectations at the outset, but one can hope that in such a simple, stationary environment individuals would

Figure 3 shows time series of realized market prices together with the individual forecasts (top panels) as well as the average forecast (middle panels) for two typical experimental groups, one stable treatment (left panels) and one strongly unstable
treatment (right panels). An immediate observation is that in the stable treatment, after a short learning phase of about 10 periods, the price volatility is low and individual forecasts as well as average forecasts are very close to the RE benchmark, with price fluctuations entirely driven by the
small random shocks in the experiments. Aggregate price behaviour and individual forecasts are very different in the strongly unstable treatment. Realized prices exhibit large fluctuations, while individual forecasts are very volatile, even towards the end of the experiment. The bottom panel of
figure 3 shows the *degree of heterogeneity*, as measured by the standard deviations of individual forecasts (6 individuals) averaged over the six groups, in the stable respectively the strongly unstable treatments. In the stable treatment heterogeneity
quickly decreases over time, showing that individuals coordinate on a forecast close to the RE-benchmark steady state. In the strongly unstable treatment heterogeneity decreases somewhat over time, but only slowly, and remains at least 3 times as high as in the stable treatment. Hence, in the
classical cobweb framework used in Muth (1961) to introduce rational expectations, our LtFEs show that *only* in the stable cobweb case, the interaction of individual forecasting rules enforces convergence to the RE-benchmark. In the unstable treatment, heterogeneity in forecasting is
persistent and leads to an aggregate effect upon prices characterized by excess volatility.

The behaviour in Figure 3 is typical for all cobweb experiments. Hommes et al. (2007) summarize the **stylized facts** of the cobweb LtFE experiments as follows: (1) the sample mean of realized prices is close to the RE benchmark
in all treatments; (2) the sample variance of realized prices depends on the treatment: it is close to the RE benchmark in the stable treatment, but significantly higher in the unstable
treatment; (3) realized market prices are irregular and do not exhibit significant linear autocorrelations.

These stylized facts across different treatments appear hard to explain by standard learning mechanisms offered by the theoretical literature. For example, naive expectations are inconsistent with the experiments, because in the unstable treatment it predicts too much regularity (convergence to
a 2-cycle) in aggregate price behavior. Average price expectations, which is just the simplest form of *adaptive learning* obtained when regressing prices on a constant, also are inconsistent with the experiments, because for both treatment it predicts convergence to the RE-benchmark (see
Fig. 2, right panel). Hommes (2009) discusses a number of other homogeneous learning algorithms and concludes that *heterogeneity* in forecasting rules is needed to explain the stylized facts of the cobweb experiments across different treatments.
Apparently, the interaction of agents' individual forecasting rules washes out linear predictability in aggregate price behavior. In the stable treatment, this interaction leads to coordination on the "correct" RE benchmark steady state, but in the unstable treatment heterogeneity persists and
prices are excessively volatile.

Hommes and Lux (2009) present a model of heterogenous individual learning via genetic algorithms (GAs) to explain the cobweb LtFEs^{3}. Genetic algorithms
require a functional specification of the forecasting rule, whose fitness-maximizing parameter values are searched for via the evolutionary algorithm. Hommes and Lux (2009) use a simple first order autoregressive rule:

Such a first order autoregressive (AR1) rule seems a natural forecasting scheme as agents could implement it using the sample average as their estimate of and the first order sample autocorrelation as the estimate of

Hommes and Lux (2009) show that the interaction of individual GA-learning rules simultaneously reproduces all stylized facts in aggregate price behaviour observed in the experiments across the different treatments. Figure shows typical price time series under GA-learning as well as time series of the two parameters in the AR1 forecasting rule for the stable treatment (left panel) and the strongly unstable treatment (right panel). In the stable treatment the parameters converge to a neighborhood of the RE benchmark, consistent with the observed coordination of individual forecasts in the experiments, while in the strongly unstable treatment parameters continue to fluctuate and prices keep moving away from the RE-benchmark, consistent with the persistent heterogeneity in the strongly unstable treatment of the experiments (cf. Fig. 3).

Before discussing the asset pricing Learning-to-forecast experiments (LtFEs) in Hommes et al. (2005), we briefly discuss the underlying benchmark model.

4.1 An asset pricing model with heterogeneous beliefs

This section discusses a standard one-period asset pricing model, extended to the case with heterogeneous beliefs, as in Campbell et al. (1997) and Brock and Hommes (1998). Agents can either invest in a risk free or in a risky asset. The risk free asset is in perfect elastic supply and pays a fixed rate of return ; the risky asset pays an uncertain dividend. Let be the price per share (ex-dividend) of the risky asset at time , and let be the stochastic dividend process of the risky asset. Next period's wealth is given by

where is the gross rate of risk free return and denotes the number of shares of the risky asset purchased at date . Let and denote the `beliefs' or forecasts of trader type about conditional expectation and conditional variance. Agents are assumed to be myopic mean-variance maximizers so that the demand of type for the risky asset solves

where is the risk aversion parameter. The demand for risky assets by trader type is then

where the conditional variance is assumed to be equal for all types and constant.

where is the number of different trader types. The forecasts of tomorrows prices and dividends are made

The quantity may be interpreted as a

In the asset pricing LtFEs six subjects are forecast advisors to large pension funds. Subjects only task is to forecast the price of a risk asset for 50 periods and, based on this forecast, the pension fund ten decides how much to invest in the risky asset according to the mean-variance demand function (4.3). The realized asset price in the experiment is given as

where is the fundamental price, is the average two-period ahead price forecast over six individuals and are small shocks, e.g. representing small random fluctuations in asset demand

The fraction of robot traders increases as the price moves further away from the fundamental benchmark. The fundamental trader thus acts as a "far from equilibrium" stabilizing force in the market, mimicking the feature that more traders in the market expect the price to return in the direction of the fundamental when the deviations becomes large

so that forecasting errors exceeding 7 would result in no reward at a given period. At the end of the session the accumulated earnings of every participant were converted to euros ( 1 point computed as in (4.8) corresponded to 50 cents).

4.3 Benchmark Simulations

Fig. 5 shows the simulation of realized prices, which would occur for a number of homogeneous benchmark expectations rules. When all individuals use the rational, fundamental forecasting rule, , for all and , the realized price randomly fluctuates around the fundamental level with small amplitude, due to the small socks. In the experiment, one can not expect rational behavior at the outset, but aggregate prices might converge to their fundamental value through individual learning. Under naive expectations the price slowly converges towards its fundamental value. The same is true under average expectations, the simplest form of adaptive learning obtained when regressing the price on a constant, but the convergence is extremely slow. If all subjects would use the simple AR2 rule

price oscillations as illustrated in the bottom right panel of Fig. 5 arise. This is an example of an

Fig. 6 shows time series of prices, individual predictions and forecasting errors in six different markets of the experiment. A striking feature of aggregate price behavior is that three different qualitative patterns emerge. The prices in groups and 5 converge slowly and almost monotonically to the fundamental price level. In groups
1 and 6 persistent oscillations are observed during the entire experiment. In
groups 4 and 7 prices are also fluctuating but their amplitude is
decreasing.^{10}

A second striking result concerns individual predictions. In all groups participants were able to *coordinate* their forecasting activity. The forecasts, as shown in the lower parts of the panels in Fig. 7, are dispersed in the first
periods but then become very close to each other in all groups. The coordination of individual forecasts has been achieved in the absence of any communication between subjects and knowledge of past and present predictions of *other* participants.

Figure 7 (right panel) illustrates the *degree of heterogeneity*, as measured by the standard deviation of individual forecasts, in three different groups. A first observation is that for each of the three groups, there is considerable *time
variation* in the degree of heterogeneity. In the converging group 2 heterogeneity quickly decreases, to a level below 1 after period 15 and close to 0 after
period 25. It should be noted that despite the fact that coordination is quick, prices are *not* close to the fundamental value. Hence, coordination on the "wrong", non-fundamental price occurs. In the oscillating group 1, heterogeneity fluctuates, with stronger coordination (i.e. a smaller
degree of heterogeneity) during trends and weaker coordination during trend reversals. The same features, but in a more extreme form, arise in the dampened oscillation group 4. During the strong trend from periods 4-13 coordination is very strong, with the degree of heterogeneity falling from a initial level above 150 to values less than 5. Thereafter, coordination weakens and the degree of heterogeneity peaks at price trend reversals, becomes very high after period 23 (note the scale on the vertical axis) with an extremely high peak around period 36-37. Note that, as heterogeneity increases, the asset price stabilizes.

To summarize, in the asset pricing LtFEs we observe the following stylized facts:

- participants were unable to learn the rational, fundamental price; only in some cases individual predictions moved (slowly) in the direction of the fundamental price towards the end of the experiment;
- alltough the sessions were designed in exactly the same, three different price patterns were observed: (i) slow, (almost) monotonic convergence, (ii) persistent price oscillations with almost constant amplitude, and (iii) large initial oscillations dampening slowly towards the end of the experiment;
- already after a short transient, participants were able to coordinate their forecasting activity, submitting similar forecasts in every period.

One would like to have a model explaining all these stylized facts simultaneously. We have not bee able to come up wit a homogeneous expectations model fitting all these experiments. The fact that qualitatively different aggregate outcomes can arise suggests that *path dependence* and
*heterogeneous expectations* play a key role.

5 A Heterogeneous Expectations Model

In the last 15 years a large literature on heterogenous agent models has developed, as surveyed e.g. by Hommes (2006) ad LeBaron(2006). In particular, Brock ad Hommes (1997) introduced a heterogeneous expectations model, where agents tend to switch towards forecasting strategies that have
performed better in the recent past. Here we discuss a modified version, a heuristics switching model, which has recently been fitted to the asset pricing LtFEs by Anufriev and Hommes (2009)^{11}.

Agents can choose from a number of simple *forecasting heuristics*. To discipline the wilderness of bounded rationality, the set of forecasting heuristics needs to be carefully chosen. We will choose forecasting heuristics that are similar to those obtained from estimations of linear models
on individual forecasting data in the LtFEs in Hommes et al. (2005) and Heemeijer et al. (2009). To further discipline the wilderness of bounded rationality two forms of individual learning are introduced. First, for some heuristics *adaptive learning* takes place, tat is,
some parameters of the heuristics are updated over time. Second, *evolutionar selection* or *performance based reinforcement learning* takes place, that is, agents evaluate the *performances* of all heuristics, and tend to switch to more successfully rules. Hence, the impact of each
of the rules is evolving over time.

To keep the model as simple as possible, Anufriev and Hommes (2009) restricted attention to only four forecasting heuristics:

ADA | (5.1) | ||

WTR | (5.2) | ||

STR | (5.3) | ||

LAA | (5.4) |

were is the sample average of past prices. The first

Subjects switch between the different forecasting rules based upon quadratic forecasting errors, consistent with the earnings incentives in the experiments. The fitness or performance measure of forecasting heuristic is given by

(5.5) |

where the parameter measure the strength of the agents'

In the special case , (5.6) reduces to the

In all simulations below, we fix the parameters at the benchmark values
^{13} and the
initial fractions of the four strategies are equal, i.e.
. The simulations thus only differ in their initial prices, which have been chosen exactly the same as in the first two periods in the corresponding experimental group

Fig. 8 compares the experimental data with the one-step ahead predictions made by the heuristics switching model, for one converging group (group 5), one oscillating group (group 6) and one dampened oscillating group (group 7); the other
groups yield very similar results; see Anufriev and Hommes (2009). Fig. 8 suggests that the switching model with four heuristics fits the experimental data quite nicely. The one-step ahead predictions of the nonlinear switching model in
Fig. 8 use past *experimental price data* to determine the forecasts and the fractions of the strategies at each period , i.e., the model simulation uses exactly the same information that was available to participants in the experiments. An immediate observations by comparing these simulations is that the one-period ahead forecasts can easily follow the different patterns in aggregate price behavior,
slow monotonic convergence, sustained oscillations as well as dampened oscillations.

The right panels in Fig. 8 show the corresponding fractions of the four strategies for each group. In different groups different heuristics are taking the lead after starting from a uniform distribution. In the monotonically converging group, the impact of the different rules stays more or less equal, although the impact of adaptive expectations gradually increases and slightly dominates the other rules in the last 25 periods. The oscillatory group yields similar results as, with the LAA rule dominating the market early and its impact increasing to about towards the end of the experiment. Finally, for the group with the dampened oscillations, one step ahead forecast produces a rich evolutionary selection dynamics (bottom panel), with three different phases where the STR, the LAA and the ADA heuristics subsequently dominate. The STR dominates during the initial phase of a strong trend in prices, but starts declining after it misses the first turning point of the trend. The LAA does a better job in predicting the trend reversal and its impact starts increasing. The LAA takes the lead in the second phase of the experiment, with oscillating prices. But the oscillations slowly dampen and therefore, after period 35, the impact of adaptive expectations, which has been the worst performing rule until that point, starts increasing and adaptive expectations dominates the groups in the last 9 periods.

6 Positive versus Negative Feedback Experiments

Aggregate price behavior in the cobweb and the asset pricing LtFEs are quite different. While in the cobweb framework the price fluctuates around its fundamental value, with a sample average of realized prices very close to the RE price, in the asset pricing experiments persistent deviations
from the fundamental price with long lasting under- or over-valuations have been observed. A key difference between the cobweb and asset pricing experiments is the type of feedback: the asset pricing (cobweb) framework exhibits positive (negative) feedback, that is the realized price depends
positively (negatively) on the average price forecast. In the case of positive (negative) feedback, when an individual forecast increases, the realized market price goes up (down). A natural question then is *whether the type of feedback, positive versus negative, explains these differences in
aggregate behavior*.

In most markets both types of feedback may play a role. Positive feedback however, seems particularly relevant in speculative asset markets. If many agents expect the price of an asset to rise they will start buying the asset, aggregate demand will increase and so, by the law of supply and demand, will the asset price. High price expectations thus become self-confirming and lead to high realized asset prices. In markets where the role of speculative demand is less important, e.g. in markets for non-storable commodities, negative feedback may play a more prominent role. Consider e.g. a supply-driven commodity market. If many producers expect future prices to be high they will increase production which, according to the law of supply and demand, will lead to a low realized market price.

Heemeijer et al. (2009) investigate how the expectations feedback structure affects individual forecasting behaviour and aggregate market outcomes by considering market environments that *only* differ in the sign of the expectations feedback, but are equivalent along all other dimensions.
In this section we discuss these experiments and apply the heterogeneous expectations model of Section 5 to see whether it can explain the different aggregate outcomes.

The distinction between positive and negative expectation feedback is related to the concepts of strategic complements versus strategic substitutes. Haltiwanger and Waldman (1985) argue that when actions are strategic complements, agents have an incentive to imitate other agents. This is the case in an asset market, where predicting a price close to the predictions of the other participants turns out to be most profitable. However, coordination of predictions enhances the impact of the irrational participants upon realized prices and convergence to the rational equilibrium price becomes unlikely. When actions are strategic substitutes, agents have an incentive to deviate from what other agents are doing. This is the case in negative feedback markets, where agents have an incentive to predict high (low) prices when the majority predicts prices below (above) the equilibrium price. The impact of irrational individuals will be limited and convergence to the equilibrium price is more likely. Coordination of predictions will only take place after convergence.

In recent experiments Fehr and Tyran (2001, 2005, 2007) study the impact of different strategic environments (strategic complementarity versus strategic substitutability) on individual rationality and aggregate outcomes. Strategic substitutability (complementarity) prevails if an increase in the action of individual i generates an incentive for j to decrease (increase) his action. Fehr and Tyran study the adjustment of nominal prices after an anticipated money shock in a price setting game with positively (complements) or negatively sloped (substitutes) reaction curves, and find much faster convergence in the case of substitutes. Sutan and Willinger (2009) investigate a new variant of beauty contest games (BCG) in which players actions are strategic substitutes versus strategic complements and find that chosen numbers are closer to rational play in the case of strategic substitutes.

In the LtFEs of Heemeijer et al. (2009), the (unknown) price generating rules in the *negative* and *positive* feedback systems were respectively:

where is a random shock to the pricing rule. First we will consider positive and negative feedback systems with small IID shocks , , and later on with large permanent shocks.

A common feature of the positive and negative feedback systems (6.1) and (6.2) is that both have the same RE equilibrium steady state ,
with when the shocks
have mean 0. The *only* difference between (6.1) and (6.2) is therefore the sign of the slope of the
linear map,
resp.
^{14}.

Figure 9 shows realized market prices as well as individual predictions in two typical groups. A striking feature is that aggregate price behavior is very different in the positive versus negative feedback cases. In the negative feedback case, the price relatively quickly settles down to the RE steady state price 60, while in the positive feedback case, the market price oscillates slowly around its fundamental value. Individual forecasting behavior is also different for the different feedback treatments: in the case of positive feedback, coordination of individual forecasts occurs extremely quickly, within 2-3 periods. The coordination however is on a "wrong" non-fundamental price. In contrast, in the negative feedback case coordination of individual forecasts is slower and takes about 10 periods. More persistence in heterogeneity of individual forecasts however ensures that, after 10 periods, the realized market price is very close to the RE benchmark of 60.

Can the heterogeneous expectations model of Section 5 explain these different outcomes in individual and aggregate behaviour? Figure 10 shows realized market prices together with the simulated prices (left panels), and the corresponding evolution of the fractions of the four strategies (right panels) of the heuristics switching model with the same benchmark parameters as before, i.e. . The model matches aggregate price behaviour in both the negative and positive feedback treatment. Furthermore, the time series of the fractions of the different forecasting heuristics (Figure 10, right panels) provide an intuitive explanation of why aggregate behavior is different. In the negative feedback treatment, the adaptive expectations strategy performs best and within 20 periods it captures more than of the market, thus enforcing convergence towards the fundamental equilibrium price. In contrast, in the positive feedback treatment the impact of the strong trend-following rule (STR) quickly increases and it captures more than of the market after 15 periods. Thereafter, the impact of the STR rule gradually declines, while the fraction of weak trend-followers (WTR) gradually increases due to the fact that the STR-rule makes (somewhat) larger mistakes (especially at the turning points) than the WTR-rule.

The difference in aggregate behavior is thus explained by the fact that trend following rules are successful in a positive feedback environment reinforcing price oscillations and persistent deviations from the fundamental equilibrium benchmark price, while the trend-following rules are driven out by adaptive expectations in the case of negative feedback.

Bao et al. (2010) recently ran similar LtFEs with large permanent shocks to the price generating mechanisms (6.1) and (6.2). These shocks have been chosen such that, both in the negative and positive feedback treatments, the fundamental equilibrium price changes over time according to:

The purpose of these experiments was to investigate how the type of expectations feedback may affect the speed of learning of a new steady state equilibrium price. Figure 11 shows realized market prices together with the simulated market prices (left panels), together with the evolution of the fractions of the four strategies of the heuristics switching model (right panels) for a typical group of the negative feedback (top panels) and the positive feedback treatment (bottom panels). The heuristics switching model is exactly the same as in Anufriev and Hommes (2009), in the case of the asset pricing experiments (see Section 5), with the same benchmark parameters as before, i.e. . As in the case of small shocks, there is a striking difference between positive and negative feedback markets. In the negative feedback market, after each large shock the price quickly (within 5 periods) settles down to the RE benchmark, while in the positive feedback market the price slowly oscillates with persistent deviations from the RE benchmark. The heuristics switching model matches both patterns quite nicely and provides an intuitive, behavioral explanation why these different aggregate patterns occur. In the negative feedback market, trend following strategies perform poorly and the adaptive expectations strategy quickly dominates the market (more than within 10 periods) enforcing quick convergence to the RE benchmark after each large shock. In contrast, in the positive feedback treatment, trend following strategies perform well, the weak trend following rule dominates in the first 20 periods, while the strong trend following rule starts dominating after the first large shock in period 22.

Figure 12 reveals some other striking features of aggregate price behavior and individual forecasts. The left panel shows the time variation of the median distance to the RE benchmark price over all groups in both treatments. For the negative
feedback treatment, after each large shock the distance spikes but converges quickly back (within 5-6 periods) to 0, while for the positive feedback treatment after each shock the distance to the RE benchmark shows a similar spike but does not converge to 0 and only decreases slowly. The right panel shows how the *degree of heterogeneity*, that is, the median standard deviation of individual forecasts, changes over time. For the positive feedback treatment after each large shock heterogeneity decreases very quickly and converges
to (almost) 0 within 3-4 periods, while in the negative treatment heterogeneity is more persistent for about 10 periods after each large shock. One may summarize
these results in saying that in the positive feedback treatment individuals quickly coordinate on a common prediction, but that coordination on the "wrong" non-fundamental price occurs. On the other hand, in the negative feedback treatment coordination is slow, heterogeneity is more persistent
but price convergence is quick. Stated differently, positive feedback markets are characterized by quick coordination and slow price discovery, while negative feedback markets are characterized by slow coordination, more persistent heterogeneity and quick price discovery. See Bao et al. (2009) for
a more detailed discussion.

7 A New Keynesian Macro Model

As a final example, we briefly discuss the LtFEs experiments in a standard New Keynesian macro model of Assenza et al. (2009); see also Pfajfar and Santoro (2009) for closely related LtFEs. The New Keynesian model is described by the following equations:

where and are respectively the actual and the expected output gap at time , is the nominal interest rate, and are respectively the actual and expected inflation rates, is the target inflation rate, , , and are positive coefficients, and and are (small) white noise shocks. The coefficient measures the response of the nominal interest rate to changes in the inflation rate . Equation (7.1) is the IS curve in which the actual output gap depends on the expected output gap and on the real interest rate . Equation (7.2) is the expectations-augmented New Keynesian Phillips curve according to which actual inflation depends on the actual output gap and expected inflation. Finally, equation (7.3) is the monetary policy rule implemented by the Central Bank in order to keep inflation at its target level .

In the LtFEs of Assenza et al. (2009), two different groups of 6 subjects have to provide two-period ahead forecasts of the inflation rate respectively the output gap for 50 periods. Realized inflation and realized output gap are determined by the (average) individual expectations of two different groups of 6 individuals. Subjects only obtain qualitative information about the macro-economy, but they do not know the underlying law of motion (7.1-7.3).

Figure 13 shows time series of realized inflation, output gap, interest rate together with individual forecasts of inflation and output gap. Both inflation and output gap exhibit dampened oscillations eventually converging to the RE benchmark steady state. An interesting feature of these experiments is that an aggressive monetary policy described by a Taylor type interest rate rule that adjust the interest rate more than one point for one in response to inflation (with a coefficient ) is able to stabilize heterogeneous expectations.

Figure 14 shows simulated time series of inflation and output gap, together with the fractions of the forecasting rules, of the benchmark heuristics switching model of Anufriev and Hommes (2009). The same heuristics switching model is used for both inflation and output gap forecasts and the model fits the experimental data quite well. The patterns of the weight of the forecasting heuristics are quite similar for inflation and output, as one would expect since both time series are qualitatively similar. The Learning Anchor and Adjustment (LAA) rule dominates most of the time, with a peak of about after 25 periods and the adaptive expectations rule dominating in the last 10 periods when the economy stabilizes. There is a slight difference in the initial phase, with the strong trend rule STR dominating inflation forecasting in periods 5-10, picking up the stronger trend in inflation.

LtFEs can be used to test theories of expectations and learning in benchmark model settings. LtFEs are Taylor made experiments to test exclusively the expectations hypothesis, computerizing all other model assumptions. Different outcomes in aggregate behavior have been observed in different
market settings. To our best knowledge, *no homogeneous* expectations model fits all LtFEs across different settings. Quick convergence to the RE-benchmark *only* occurs in stable (i.e. stable under naive expectations) cobweb/negative feedback markets.

Lab experiments suggest that *heterogeneity* is a crucial aspect of a theory of expectations, because a *heterogeneous expectations model* can explain observed *path dependence* in the same market environment as well as different aggregate outcomes across different market
settings.

A challenge to economic theory is to come up with a universal and plausible theory of heterogeneous expectations. The fact that a simple heuristics switching model fits different LtFEs gives some hope that a general heterogeneous expectations hypothesis may explain individual expectations and aggregate outcomes across different market settings.

Experimental evidence on the persistence of output and inflation, *The Economic Journal* 117 (520) , 603-636 .

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press.

Charts, noise and fundamentals in the London foreign exchange market, *Economic Journal* 100, No. 400, Conference Papers, 49-59.

Do heterogeneous beliefs matter for asset pricing? *Review of Financial Studies* 18, 875-924.

Evolutionary Selection of Individual Expectations and Aggregate Outcomes, *CeNDEF Working Paper* 09-09, University of Amsterdam, September 2009.

"Genetic algorithm learning and the cobweb model." *Journal of Economic Dynamics and Control* 18(1): 3-28.

Tests for bounded rationality with a linear dynamic model distorted by heterogeneous expectations, *Journal of Economic Dynamics and Control* 23, 1517-1543.

Individual expectation, limited rationality and aggregate outcome, *CeNDEF working paper*, January 2010.

A survey of behavioral finance, *Handbook of the Economics of Finance*, In: Constantinidis, G.M. et al. (Eds.), Elsevier.

A model of dynamic equilibrium asset pricing with heterogeneous beliefs and extraneous risk, *Journal of Economic Dynamics and Control* 24, 63-95.

Models of exchange rate expectations: how much heterogeneity?, *International Financial Markets, Institutions and Money* 13, 113-136.

Heuristics and biases in retirement savings behavior, *Journal of Economic Perspectives* 21, 81-104.

Behavioral heterogeneity in stock prices, *Journal of Economic Dynamics and Control* 31, 1938-1970.

Does Volatility matter? Expectations of price return and variability in an asset pricing experiment, CEEL Working Paper 1-08.

The theory of rationally heterogeneous expectations: evidence from survey data on inflation expectations, *Economic J.* 114, 592-621.

Sticky information and model uncertainty in survey data on inflation expectations, *Journal of Economic Dynamics and Control* 31

Intrinsic heterogeneity in expectation formation, *Journal of Economic Theory* 127, 264-295.

A rational route to randomness, *Econometrica* 65, 1059-1095.

Heterogeneous beliefs and routes to chaos in a simple asset pricing model, *J. Econ. Dyn. & Contr.* 22, 1235-1274.

Experienced-weighted attraction learning in normal form games, *Econometrica* 67, 827-874.

The Econometrics of Financial Markets, Princeton University Press, Princeton.

Disagreement and biases in inflation expectations, *Journal of Money, Credit and Banking* 41, 365-396.

The stability of an experimental market with a supply response lag, *Southern Economic Journal* 33, 305–321.

On information and market dynamics: the case of the U.S. beef market, *Journal of Economic Dynamics and Control* 24, 833-853.

Heterogeneity, market mechanisms, and asset price dynamics, In: Hens, T. and K. R. Schenk-Hoppé (Eds.), *Handbook of Financial Markets: Dynamics and Evolution*, Elsevier, pp. 277-344.

. The Financial Crisis and the Systemic Failure of Academic Economics, Univ. of Copenhagen Dept. of Economics Discussion Paper No. 09-03. Available at SSRN: http://ssrn.com/abstract=1355882

Ways of learning in a simple economic setting: a comparison, *Chaos, Solitons and Fractals* 29, 653-670.

What's wrong with modern macroeconomics. Top-down versu bottom-up macroeconomics, CESifo Economic Studies Conference Paper, November 2009.

Emergent macroeconomics. An agent-based approach to business fluctuations, Springer Verlag, Milan.

Noise trader risk in financial markets, *Journal of Political Economy* 98, 703-738.

Herding, A-synchronous Updating and Heterogeneity in Memory in a CBS, *Journal of Economic Dynamics and Control* 29, 741-763.

What drives heterogeneity in foreign exchange rate expectations: insights from a new survey, *International Journal of Finance and Economics* 13, 360-367.

Agent-based models and human-subject experiments, in Leigh Tesfatsion and Kenneth L. Judd (ed.), **Handbook of Computational Economics**, edition 1, volume 2, chapter 19, pages 949-1011.

Experimental Macroeconomics, Entry in: S. Durlauf and L. Blume, (Eds.), The New Palgrave Dictionary of Economics, 2nd ed., New York: Palgrave Macmillan.

Macroeconomics: a survey of laboratory research, In: J. Kagel A.E. Rot, (Eds.), *Handbook of Experimental Economics*, Volume 2, forthcoming.

Oil price dynamics: a behavioral finance approach with heterogeneous agents, Working Paper, Erasmus University Rotterdam.

Heterogeneous expectations and tests of efficiency in the yen/dollar forward exchange rate market, *Journal of Monetary Economics* 43, 435-456.

Prediction how people play games: reinforcement learning in games with unique strategy equilibrium, *American Economic Review* 88, 848-881.

Learning and expectations in macroeconomics, Princeton University Press, Princeton.

The virtures and vices of equilibrium and the future of financial economics, *Complexity* 14, 11-38.

Does money illusion matter? *American Economic Review* 91, 1239-1262.

Individual irrationality and aggregate outcomes, *Journal of Economic Perspectives* 19, 43-66.

Limited rationality and strategic interaction: the impact of the strategic environment on nominal inertia, *Econometrica* 76, 353-394.

Short-term and Long-term Expectations of the Yen/Dollar Exchange Rate: Evidence from Survey Data, *Journal of the Japanese and International Economies* 1, 249-274; also published as *NBER working paper* 2216, April 1987.

The Rationality of the Foreign Exchange Rate. Chartists, Fundamentalists and Trading in the Foreign Exchange Market, *American Economic Review* 80, no. 2, AEA Papers and Proceedings, 181-185.

Expectation formation and stability in large socio-economic systems, *Econometrica* 66, 741-781.

Traders' expectations in asset markets: experimental evidence, *American Economic Review* 97, 1901-1920.

Price stability and volatility in markets with positive and negative expectations feedback, *Journal of Economic Dynamics & Control*, 1052-1072.

A laboratory experiment with a single person cobweb, *Atlantic Economic Journal* 14, 51–54.

Heterogeneous agent models in economics and finance, In: Tesfatsion, L. and Judd, K.L., (eds), *Handbook of Computational Economics, Volume 2: Agent-Based Comp. Econ.*, chapter 23, North-Holland, 1109-1186.

Bounded Rationality and Learning in Complex Markets, In: *Handbook of Economic Complexity*, Edited by J. Barkley Rosser, Jr., Cheltenham: Edward Elgar.

A robust rational route to randomness in a simple asset pricing model. *Journal of Economic Dynamics and Control* 29, 1043-1072.

Individual Expectations and Aggregate Behavior in Learning to Forecast Experiments, *CeNDEF Working Paper*, University of Amsterdam.

Coordination of expectations in asset pricing experiments, *Review of Financial Studies* 18, 955-980.

Learning in cobweb experiments, **Macroeconomic Dynamics** 11 (S1), 8-33.

Expectations and bubbles in asset pricing experiments, *Journal of Economic Behavior & Organization* 67, 116-133.

Expectation formation in an experimental cobweb economy, In: D. Delli Gatti, M. Gallegati and A. Kirman (eds.). Interaction and Market Structure: Essays on Heterogeneity in Economics, *Lecture Notes in Economics and Mathematical Systems*, volume 484, pp. 253–266.
Berlin: Springer-Verlag

Consistent Expectations Equilibria, *Macroeconomic Dynamics* 2, 287-321.

Complex Evolutionary Systems in Behavioral Finance, In: T. Hens and K.R. Schenk-Hoppé (Eds.), *Handbook of Financial Markets: Dynamics and Evolution*, Elsevier, 2009, 217-276.

Behavioural heterogeneity and shift-contagion: Evidence from the Asian crisis, *Journal of Economic Dynamics and Control* 33, 1929-1944.

, Learning to Forecast Price, *Economic Inquiry*, 40, 556-573.

Agent-based Computational Finance, *Handbook of Computational Economics, Volume 2: Agent-Based Computational Economics*, chapter 24, L. Tesfatsion and K.L. Judd (Eds.), North-Holland, Amsterdam, 1187-1233.

Nonspeculative bubbles in experimental asset markets: lack of common knowledge of rationality vs. actual irrationality, *Econometrica* 69, 831-859.

Specialization and herding behavior of trading firms in a financial market, New Journal of Physics 10, 043019.

Econometric testing of the natural rate hypothesis, In: O. Eckstein (ed.) The econometrics of price determination Conference. Board of Governors of the Federal Reserve System and Social Science Research Council, Washington DC, 1972, 50-59.

Adaptive behavior and economic theory, *Journal of Business* 59 (4), S401-S426.

Stochastic behavioral asset pricing models and the stylized facts, In: T. Hens and K.R. Schenk-Hoppé (Eds.), *Handbook of Financial Markets: Dynamics and Evolution*, Elsevier, 2009.

Currency forecasters are heterogeneous: confirmation and consequences, *Journal of International Money and Finance* 15, 665-685.

Disagreement about inflation expectations, In: Gertler, M., Rogoff, K. (Eds.), NBER Macroeconomics Annual 2003.

, Expectationally Driven Market Volatility: an Experimental Study, *Journal of Economic Theory*, 61, 74-103.

Indeterminacy of Equilibria in a Hyperinflationary World: Experimental Evidence, *Econometrica* 61, 1073-1107.

Expectations and Learning under Alternative Monetary regimes: an experimental approach, *Economic Theory* 4, 131-162.

Does a constant money growth rule help stabilize inflation? *Carnegie-Rochester Conference Series on Public Policy* 43, 111-156.

The obstinate passion of foreign exchange professionals: technical analysis, *Journal of Economic Literature* 45, 936-972.

Rational expectations and the theory of price movements, Econometrica 29, 315-335.

Survey expectations, In: G. Elliott, C.W.J. Granger and A. Timmermann, *Handbook of Economic Forecasting*, Amsterdam, North-Holland, pp.715-76.

Efficiency of experimental security markets with insider information: an application of rational expectations models, *Journal of Political Economy* 90, 663-698.

Bounded rationality in macroeconomics, Clarendon Press.

Evolution and intelligent design, *American Economic Review* 98, 5-37.

An Experimental Study of Expectation Formation, *Econometrica*, 44, 17-41.

Behavioral heterogeneity in dynamic search situations: Theory and experimental evidence, *Journal of Economic Dynamics and Control* 33, 1719-1738.

Behavioral capital asset pricing theory, *The Journal of Financial and Quantitative Analysis* 29, 323-349.

Measuring bubble expectations and investor confidence, *Journal of Psychology and Financial Markets* 1, 49-60.

Models of man, Wiley, New York, NY.

Macroeconomics and reality, *Econometrica* 48, 1-48.

A experimetal stud of competitive market beavior, *Joural of Political Ecoom* 70, 111-137.

Bubbles, Crashes and Endogenous Expectations in Experimental Spot Asset Markets, *Econometrica*, 56, 1119-1151.

Experimental asset markets: a survey: In: J.H. Kagel and A.E. Roth, (Eds.), *Handbook of Experimental Economics*, Princeton University Press, 445-500.

Guessing with negative feedback: An experiment, *Journal of Economic Dynamics and Control* 33, 1123-1133.

The use of technical analysis in the foreign exchange market, *Journal of International Money and Finance* 11, 304-314.

Judgment under uncertainty: heuristics and biases, *Science* 185, 1124-1131.

An Experimental Approach to Expectation Formation in Dynamic Economic Systems, Ph-D Dissertation, Tinbergen Institute Research Series 268.

The Formation of Price Forecasts in Experimental Markets, *Journal of Money, Credit and Banking*, 19, 1-18.

Scaling laws of strategic behavior and size heterogeneity in agent dynamics, Physical Review E 77, 036110.

Perspective on behavioral finance: does `irrationality' disappear with wealth? Evidence from expectations and actions, In: Gertler, M., Rogoff, K. (Eds.) *NBER Macroeconomics Annual*, MIT Press.

A Laboratory Analysis of Price Dynamics and Expectations in the Cobweb Model, Discussion Paper No. 89-15, Department of Economics, University of Arizona

Capital asset prices with heterogeneous beliefs, *Journal of Financial Economics* 5, 219-239.

Effects of financial innovation on market volatility when beliefs are heterogeneous, *Journal of Economic Dynamics and Control* 22, 597-626.

#### Footnotes

^{♣} This version is optimized for use by screen readers. Descriptions for all mathematical expressions are provided in LaTex format. A printable pdf version is available. Return to Text

* This work was presented at a plenary lecture at the 15th International Conference on Computing in Economics and Finance (CEF), Sydney, July 15-17, 2009. I would like to thank the participants of the CEF-conference for many stimulating discussions. This
survey is based on longlasting cooperation and many ideas from my co-authors Joep Sonnemans, Jan Tuinstra, Henk van de Velden, Peter Heemeijer, Buz Brock and Tiziana Assenza and particularly benefitted from ideas, simulations and figures provided by Mikhail Anufriev, Te Bao, Domenico Massaro and
Thomas Lux. Financial support from the EU 7th framework collaborative project *Monetary, Fiscal and Structural Policies with Heterogeneous Agents (POLHIA)*, grant no. 225408, is gratefully acknowledged. None of the above are responsible for errors in this paper. Return to Text

1. There is also an extensive literature on heterogeneous belief models based on heterogeneous information, see e.g. Williams (1977), Shefrin and Statmann (1994), Zapatero (1998), Basak (2000) and Anderson et al. (2005). Return
to Text

2. 1300 points corresponded to 0.5 Euro, so
that maximum earnings were 25 Euro's. Average earnings ranged from 11.5 to
21 Euro (in about 1.5 hours), over the different treatments. Return to Text

3. Colucci and Valori (2006) fit simple adaptive learning rules to the individual cobweb LtFE of Hommes et al. (2000). Arifovic (1994) calibrates a GA-learning model to the cobweb experiments of Wellford (1989). Return to
Text

4. See Hommes and Sorger (1998), where the parameters of an AR1 rule are updated according to sample autocorrelation learning. Return to Text

5. In similar cobweb LtFE experiments Heemeijer et al. (2009) recently estimated individual forecasting rules, and many individuals actually used forecasting rules of the simple AR1-form (3.7). Return
to Text

6. Gaunersdorfer (2000) studies the case with time varying beliefs about variances and Chiarella and He (2002,2003) investigate the model with heterogeneous risk aversion coefficients. Return to Text

7. Bottazzi et al. (2008) consider asset pricing LtFEs were, in addition to a price forecast subjects must also forecast the variance of excess returns, which is then used in the mean-variance demand function (4.3) to compute the market
clearing price. Return to Text

8. In the experiment never exceeds 0.25, while the weight of the other traders are equal to
. Hommes et al. (2008) investigate price behavior in asset pricing LtFEs *without* robot traders. Return to Text

9. At this stage one could argue that the anchor of this rule, defined as the average between the last observed price and the fundamental price, was unknown in the experiment, since subjects were not provided explicitly with the fundamental price. It is
remarkable however that for a number of subjects the linear estimated forecasting rule was surprisingly close to the anchor and adjustment rule (4.9) Return to Text

10. Price dynamics in group 3 (not shown, but see the concluding remarks) is more difficult to classify. Similar to group it started with moderate oscillations, then stabilized at a level below the fundamental, suddenly falling in period , probably due to a typing error of one of the participants. Return to Text

11. The heuristics switching model is similar to other models of reinforcement learning, e.g. Erev and Roth (1998) and Camerer and Ho (1999). An important difference however is that our model is built in a market environment rather than the strategic
environments usually studied in standard game theory. Schunk (2009) introduces a dynamic model of behavioral heterogeneity in search behavior and shows that his experimental data is well explained by a model assuming dynamic updating of utility reference points. Return to Text

12. Haruvy et al. (2007) also provide experimental evidence that individual price expectations are significantly affected by past price trends. Trend following behavior is often associated with technical trading strategies in real financial markets; see
Menkhoff and Taylor for a comprehensive overview of the importance of technical analysis. Return to Text

13. These values have been obtained in Anufriev and Hommes (2009) after some trial and error simulations. The simulation results however are fairly robust with respect to small changes in these parameter values. Return to
Text

14. In both treatments, the absolute value of the slopes is 0.95, implying in both cases that the feedback system is stable under naive expectations
Return to Text