CALCULATION, ADAPTATION AND RATIONAL EXPECTATIONS

We propose an active cognition approach to bounded rationality, in which agents use a calculation algorithm to improve on the forecasts provided by a purely adaptive learning rule such as least-squares learning. Agents' choices of calculation intensity depend on their estimates of the benefits of improved forecasts relative to calculation costs. Using an asset-pricing model, we show how more rapid adjustment to rational expectations and forward-looking behavior arise naturally when there are large anticipated structural changes such as policy shifts. We also give illustrative applications in which the severity of asset price bubbles and the intensity of hyperinflationary episodes are related to the cognitive ability of the agents.

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INEFFICIENT BUBBLES AND EFFICIENT DRAWDOWNS IN FINANCIAL MARKETS

International Journal of Theoretical and Applied Finance ◽

10.1142/s0219024920500478 ◽

2020 ◽

Vol 23 (07) ◽

pp. 2050047 ◽

Cited By ~ 1

Author(s):

MICHAEL SCHATZ ◽

DIDIER SORNETTE

Keyword(s):

Rational Expectations ◽

Rational Expectation ◽

Asset Price ◽

Theoretical Background ◽

Local Martingale ◽

Management Problem ◽

Market Failures ◽

Asset Price Bubbles ◽

Price Bubbles ◽

Hyman Minsky

At odds with the common “rational expectations” framework for bubbles, economists like Hyman Minsky, Charles Kindleberger and Robert Shiller have documented that irrational behavior, ambiguous information or certain limits to arbitrage are essential drivers for bubble phenomena and financial crises. Following this understanding that asset price bubbles are generated by market failures, we present a framework for explosive semimartingales that is based on the antagonistic combination of (i) an excessive, unstable pre-crash process and (ii) a drawdown starting at some random time. This unifying framework allows one to accommodate and compare many discrete and continuous time bubble models in the literature that feature such market inefficiencies. Moreover, it significantly extends the range of feasible asset price processes during times of financial speculation and frenzy and provides a strong theoretical background for future model design in financial and risk management problem settings. This conception of bubbles also allows us to elucidate the status of rational expectation bubbles, which, by design, suffer from the paradox that a rational market should not allow for misvaluation. While the discrete time case has been extensively discussed in the literature and is most criticized for its failure to comply with rational expectations equilibria, we argue that this carries over to the finite time “strict local martingale”-approach to bubbles.

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Monetary Policy and Rational Asset Price Bubbles: Comment

The American Economic Review ◽

10.1257/aer.20180145 ◽

2019 ◽

Vol 109 (5) ◽

pp. 1969-1990 ◽

Cited By ~ 8

Author(s):

Jianjun Miao ◽

Zhouxiang Shen ◽

Pengfei Wang

Keyword(s):

Monetary Policy ◽

Steady State ◽

Adaptive Learning ◽

Asset Price ◽

Optimal Monetary Policy ◽

Asset Price Bubbles ◽

Price Bubbles ◽

Leaning Against The Wind ◽

Stable Variable ◽

Forward Looking

We revisit Galí’s (2014 ) analysis by extending his model to incorporate persistent bubble shocks. We find that, under adaptive learning, a stable bubbly steady state and the associated sunspot solutions under optimal monetary policy are not E-stable. When deriving the unique forward-looking minimum stable variable (MSV ) solution around an unstable bubbly steady state, we obtain results that are consistent with the conventional views: leaning against the wind policy reduces bubble volatility and is optimal. Such a steady state and the associated MSV solution are E-stable. (JEL E13, E32, E44, E52, G12)

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Monetary Policy and Bubbles in a New Keynesian Model with Overlapping Generations

American Economic Journal Macroeconomics ◽

10.1257/mac.20180427 ◽

2021 ◽

Vol 13 (2) ◽

pp. 121-167

Author(s):

Jordi Galí

Keyword(s):

Monetary Policy ◽

Rational Expectations ◽

Overlapping Generations ◽

Asset Price ◽

New Keynesian ◽

New Keynesian Model ◽

Asset Price Bubbles ◽

Price Bubbles ◽

Keynesian Model ◽

Welfare Implications

I analyze an extension of the New Keynesian model that features overlapping generations of finitely lived agents and (stochastic) transitions to inactivity. In contrast with the standard model, the proposed framework allows for the existence of rational expectations equilibria with asset price bubbles. I study the conditions under which bubble-driven fluctuations may emerge and the type of monetary policy rules that may prevent them. I conclude by discussing some of the model’s welfare implications. (JEL E12, E32, E44, E52, E63)

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BOLHAS RACIONAIS, CICLO DE PREÇOS DE ATIVOS E RACIONALIDADE LIMITADA: UMA AVALIAÇÃO CRÍTICA DOS MODELOS NEOCLÁSSICOS DE BOLHAS ESPECULATIVAS

Análise Econômica ◽

10.22456/2176-5456.10732 ◽

2009 ◽

Vol 21 (40) ◽

Author(s):

José Luís Oreiro

Keyword(s):

Bounded Rationality ◽

Rational Expectations ◽

Multiple Equilibria ◽

Asset Price ◽

Complete Information ◽

Unified Framework ◽

Asset Price Bubbles ◽

Price Bubbles ◽

Starting Point ◽

Asset Price Cycles

The objective of this article is to criticize neoclassical models of asset price bubbles and to argue that a general theory of asset price cycles demands the substitution of rational expectations hypothesis for bounded rationality assumption. In order to do that we will initially present the two neoclassical approaches for the problem of asset price bubbles. The first one, based on models of multiple equilibria with rational expectations, take financial markets as competitive and investors's behavior as based on perfect and complete information. In this setting, asset bubbles are a logically possible but unprobable phenomenon since their ocurrence will be associated with problems of dynamic ineficience which are not a relevant problem for most of capitalist economies. The second approach, initially developed by Krugman, take as a starting point the idea that financial market are far from perfect. In fact, these markets have a great number of imperfections as, for example, moral hazard. In this approach, asset price bubbles are the result of trading in assets with low supply-price elasticity as, for example, equities and land. Although this second approach is more realistic than the first, it is not capable to explain in a unified framework the appearance, propagation and burst of the speculative bubble; i.e the phenomenon of asset price cycles. This second approach is only capable to show the conditions for the existence of an asset bubble; but it is not capable to explain the dynamic evolution of the bubble. This question is better adressed by heterodox literature based on the hypothesis of bounded rationality.

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