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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page ``Forecasting the Forecasts of Others:'' Expectational Heterogeneity and Aggregate Dynamics
Antulio N. Bomfim

Abstract: I construct a dynamic general equilibrium model where agents differ in the way they form expectations. Sophisticated agents form model-consistent expectations. Rule-of-thumb agents' expectations are based on an intuitive forecasting rule. All agents solve standard dynamic optimization problems and face strategic complementarity in production. Extending the work of Haltiwanger and Waldman (1989), I show that even a minority of rule-of-thumb forecasters can have a significant effect on the aggregate properties of the economy. For instance, as agents try to forecast each others' behavior they effectively strengthen the internal propagation mechanism of the economy. I solve the model by assuming a hierarchical information structure similar to the one in Townsend's (1983) model of informationally dispersed markets. The quantitative results are obtained by calibrating the model and running a battery of sensitivity tests on key parameters. The analysis highlights the role of strategic complementarity in the heterogeneous expectations literature and precisely quantify many qualitative claims about the aggregate implications of expectational heterogeneity.

Keywords: Business cycles, expectatations, strategic complementarity, bounded rationality

Full paper (214 KB PDF) | Full paper (367 KB Postscript)

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