An Econometric Analysis of Polish Inflation Dynamics with Learning about Rational Expectations

Abstract

Rational expectations modelling has been criticized for assuming that economic agents can learn quickly about and compute rational price expectations. In response, various authors have studied theoretical models in which economic agents use adaptive statistical rules to develop price expectations. A goal of this literature has been to compare resulting learning equilibria with rational expectations equilibria. The lack of empirical analysis in this literature suggests that adaptive learning makes otherwise linear dynamic models nonlinearly intractable for current econometric technology. In response to the lack of empirical work in this literature, this paper applies to post-1989 monthly data for Poland a new method for modelling learning about price expectations. The key idea of the method is to modify Cagan’s backward-looking adaptive-expectations hypothesis about the way expectations are actually updated to a forward-looking characterization which instead specifies the result of learning. It says that, whatever the details of how learning actually takes places, price expectations are expected to converge geometrically to rationality. The method is tractable because it involves linear dynamics. The paper contributes substantively by analyzing the recent Polish inflation, theoretically by characterizing learning, and econometrically by using learning as a restriction for identifying (i.e., estimating wth finite variance) unobserved price expectations with the Kalman filter.