Heterogeneous forecasts and aggregate dynamics

Abstract

Motivated by issues raised in both the finance and economics literatures, I construct a dynamic general equilibrium model where agents use differing degrees of sophistication when forecasting future economic conditions. All agents solve standard dynamic optimization problems and face strategic complementarity in production, but some solve their inference problems based on simple forecasting rules of thumb. Assuming a hierarchical information structure similar to the one in Townsend's (J. Political Econom. 91 (1983) 546–588) model of informationally dispersed markets, 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. 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 quantifies many qualitative claims about the aggregate implications of expectational heterogeneity.