Abstract
This paper considers various types of forecast heuristics to examine the effects of boundedly rational agents on macroeconomic dynamics. Given the baseline New Keynesian model, we seek to find the expectation formation process that is most suitable in describing economic adjustments over the business cycle. In particular, impulse response analysis is used to compare the performances of the macroeconomic model under bounded rationality and under rational expectations. The results show that the fluctuations in consumer confidence mainly explain the degree of persistence in consumption. We conclude that a model under bounded rationality with a heuristic-induced switching process can qualitatively provide a good fit to the data that is equivalent to a model under rational expectations.
Highlights
Modern macroeconomic models often rely on the rational expectations (RE) hypothesis to avoid the complexity of multiperiod optimization problems in economic activities
This paper considers various types of forecast heuristics to examine the effects of boundedly rational agents on macroeconomic dynamics
We show that the macroeconomic dynamics driven by heuristics can provide a good fit to the data that is equivalent to a RE model with a lead and lag structure
Summary
Modern macroeconomic models often rely on the rational expectations (RE) hypothesis to avoid the complexity of multiperiod optimization problems in economic activities. As the field of behavioral and experimental economics gradually matures, the notion of bounded rationality (BR) provides a benchmark against which agents attempt to forecast events Heuristics, such as rules-of-thumb procedures, are applied as a convenient way to describe the reality and complexity of economic activities. Feature of the BR model framework, agents are allowed to switch to the group with the best performing forecast strategy as evaluated based on discrete choice theory Their results suggest that expectations in the US economy are grounded on the consumers’ emotional state, whereas in the Euro Area, they are purely technical. The remainder of this paper is structured as follows: Section 2 discusses the general representation of the model frameworks under RE and BR The latter includes the description of the forecast heuristics applied while considering the discrete choice mechanism. The technical details and additional results are relegated to “Appendix”
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