Expectation Formation Mechanisms Research Articles

The Impact of Credit Market Sentiment Shocks

AbstractThis paper investigates the role of credit market sentiment and investor beliefs in credit cycle dynamics and their transmission to businesscycle fluctuations. Using U.S. data from 1968 to 2014, we find that credit market sentiment is indeed able to detect asymmetries in a small‐scale macroeconomic model. An unexpected credit market sentiment shock has different impacts in an optimistic and pessimistic credit market environment. While an unexpected movement in the optimistic regime leads to a rather muted impact on output and credit, we find a significant negative impact on these variables in the pessimistic regime. The findings highlight the relevance of expectation formation mechanisms as a source of macroeconomic instability.

Senior bank loan officers’ expectations for loan demand: A note

We employ senior bank loan officers’ responses regarding actual and expected loan demand from enterprises linking successive surveys to determine the dominant expectation formation mechanism that best describes European senior bank loan officers’ expectations. Our findings suggest that the adaptive expectations mechanism is compatible with senior bank loan officers’ expectations for loan demand from enterprises. Our study contributes to the understanding of the formation of loan demand expectations, and hence our findings can be beneficial for monetary policy purposes.

How Large is the Output Cost of Disinflation?

This paper examines estimates of, and drivers for, the sacrifice ratio in the United States. Three approaches are employed. The first reviews the literature on what sacrifice ratio might be expected. The second studies a generic disinflation experiment using 40 estimated macro models of the U.S. economy, calculating a distribution of sacrifice ratios. Those sacrifice ratios are high by historical standards and the paper discusses some stories for why this is so. The role of expectations formation and the credibility of policy is emphasized. The third approach gets under the hood of drivers of the output cost of disinflation by carrying out a selection of disinflation experiments using the FRB/US model, varying certain characteristics of the model’s expectations formation mechanism. Pinning down a precise measure for the output cost of disinflation is challenging. But the literature and policy experiments do offer some guidance on how the sacrifice ratio can be reduced.

Political and Social Consequences of Qualification Mismatches: A Bounding Approach to Status Inconsistency

Abstract Many employees work in jobs that do not match their level of formal education. Status inconsistency theory (SIT) argues that such mismatches result in stress, dissatisfaction, political alienation, and social withdrawal. Status inconsistency may, therefore, pose a threat to social cohesion. However, extant SIT scholarship does not fully appreciate the consequences of an identification problem due to the perfect collinearity among the effects of occupation, education, and their mismatch. I review the literature and show that prior findings depend on implicit theoretical assumptions that are often implausible once spelled out. To overcome this problem, I propose a new approach to the study of mismatches that builds on recent advances in the modeling of age, period, and cohort effects. I demonstrate how a set of relatively weak assumptions that are transparently grounded in sociological theory allows for (partial) identification of mismatch effects. The empirical analysis draws on comparable large-scale survey data from the United Kingdom (UKLHS) and Germany (GSOEP), two countries with a very different institutional organization of education to job matching. Compared with previous research, I use theoretically justified identifying assumptions and provide more rigorous evidence by addressing non-random selection into mismatch. Constrained regression models show mismatch effects on work-related identities, satisfaction, and organizational integration. Contra SIT, my results suggest that the effects of mismatches do not arise from cognitive dissonance but from an expectation formation mechanism. I find only weak evidence that mismatch effects spill over into the political domain. Despite large institutional differences, the results are similar across countries.

Monetary policy strategies in the New Normal: A model-based analysis for the euro area

A calibrated New Keynesian model of the euro area is used to evaluate the stabilization properties of alternative monetary policy strategies when the natural rate of interest is low (“new normal”) and the probability of reaching the effective lower bound (ELB) is non-negligible. Price level targeting is the most effective strategy in terms of stabilizing inflation and output and reducing the duration and frequency of ELB episodes. Temporary price level targeting is also effective in mitigating the ELB constraint, although its stabilization properties are inferior to those of price level targeting. Backward-looking average inflation targeting performs well and is preferable to inflation targeting. The effectiveness of these alternative strategies hinges upon the commitment of a central bank to keeping the policy rate “lower for longer” and is influenced by agents’ expectation formation mechanism.

Are firms' expectations on the availability of external finance rational, adaptive or regressive?

PurposeThis study investigates which expectation formation mechanism governs Eurozone firms regarding their expectations on external finance availability.Design/methodology/approachIn this study, we link consecutive surveys from the Survey on the Access to Finance of Enterprises to bring new evidence on how non-financial corporations shape their expectations on external finance availability.FindingsIn line with the past literature, we demonstrate that the data reject the Rational Expectations hypothesis, and we find evidence in favor of the Adaptive Expectation mechanism.Originality/valueThis is the first study studying firms' expectations of external finance availability, implementing survey data of firms' expectations from the SAFE database on a country level. The formation of firm expectations is vital in directing policymakers in designing appropriate monetary policies, as both the employment and inflation targets of central banks around the world are highly dependent on the firm-level decision process.

Learning in a double-phase cobweb model

In this paper, we study a class of markets, among which we can mention agricultural and energy markets, characterized by seasonality, i.e., in which demand and/or supply conditions cyclically alternate with a precise and known periodicity. We propose a new theoretical framework based on a cobweb model with adaptive expectations, accordingly modified to be consistent with market’s seasonality. The model, consisting in a second-order non-autonomous difference equation, is investigated with the aim of understanding how the periodical nature of the market together with the agents’ expectation formation mechanism affects the resulting dynamics. We analytically prove the emergence of dynamical scenarios that are missing in the classic cobweb model for non-seasonal markets, such as quasi-periodic dynamics and an ambiguous role on stability of the expectation weight. Finally, we discuss their economic rationale with the help of numerical simulations. In such a peculiar economic framework, agents’ learning plays a key role to explain the dynamical properties of economic observables.

Heterogeneous expectations, forecasting behaviour and policy experiments in a hybrid Agent-based Stock-flow-consistent model

This paper presents a hybrid agent-based stock-flow-consistent model featuring heterogeneous banks, purposely built to examine the effects of variations in banks’ expectations formation and forecasting behaviour and to conduct policy experiments with a focus on monetary and prudential policy. The model is initialised to a deterministic stationary state and a subset of its free parameters are calibrated empirically in order to reproduce characteristics of UK macro-time-series data. Experiments carried out on the baseline focus on the expectations formation and forecasting behaviour of banks through allowing banks to switch between forecasting strategies and having them engage in least-squares learning. Overall, simple heuristics are remarkably robust in the model. In the baseline, which represents a relatively stable environment, the use of arguably more sophisticated expectations formation mechanisms makes little difference to simulation results. In a modified version of the baseline representing a less stable environment alternative heuristics may in fact be destabilising. To conclude the paper, a range of policy experiments is conducted, showing that an appropriate mix of monetary and prudential policy can considerably attenuate the macroeconomic volatility produced by the model.

A time-varying expectations formation mechanism

We propose an expectations formation mechanism (EFM) aimed to explain the median—hence lay—forecaster’s year-ahead inflation predictions. The EFM is a time-varying combination of long-run expectations, current inflation and uncertainty with weights naively calibrated according to inflation dynamics. Earning fixed income, in fact, the median forecaster has an aversion toward underestimation that increases with inflation. To allow for occasional—albeit unintentional—cost-minimizing calibrations, the EFM nests various forecasting rules. Data from the Michigan Survey of Consumers sustains the argued behavior and contributes to interpret some puzzling price dynamics such as the missing disinflation and reflation.

Macroeconomics, rationality, and institutions

This special issue, “Macroeconomics, rationality, and institutions,” explores the role of institutions in macro models in which agents have limited rationality or interact strategically. We aim to contribute to the refinements and developments of the macro-models along several directions: The analyses of financial frictions, learning processes and expectation formation mechanisms, the study of strategic interactions and of the heterogeneity among agents, and the resulting implications for the design of institutions and (optimal) policies. These developments not only improve our understanding of the macroeconomic interactions among agents, but also contribute to answer several open questions regarding relevant policy issues, such as the power and relevance of forward guidance or quantitative easing. This introductory article reviews the recent debate on the role of DSGE models, heavily criticized after the financial crisis, to provide the background for the contributions presented in this issue. We also briefly review the articles presented in this special issue.

A note on bank loan officers' expectations for credit standards: Evidence from the European bank lending survey

AbstractWe employ quarterly credit standards data from the Bank Lending Survey, covering 14 EU countries for the period 2003 Q1 to 2016 Q1. By linking consecutive surveys and utilizing loan officers' responses regarding actual and expected credit standards, we set out to investigate which expectations formation mechanism best describes loan officers' expectations. According to our findings, bank loan officers' expectations are compatible with the adaptive expectations mechanism.

Impact of Monetary Supply on Chinese Nonferrous Metal Price Movement*

Employing both classical vector autoregressive methodology and regression models utilizing shock factors constructed with the Hodrick–Prescott filtering method, this paper empirically studies the influence of monetary factors on the price of nonferrous metals and their expectation formation in the Chinese market. Monetary factors are found to significantly positively influence Chinese nonferrous metal prices, and further empirical research reveals that a structural change occurred near August 2006. There is an expectation formation mechanism of lagged futures prices on spot metal prices, and the risk originating primarily from international market is transmitted to Chinese markets.

Expectation Formation in Politics of Trade Liberalization: Population Aging and Uncertainty

Expectation formation about future trade liberalization induces sectoral adjustment in advance and so the number of opposition decreases and trade liberalization can be self-fulfilling. We analyze this expectation formation mechanism in political process from two aspects: population aging and uncertainty. Then, we show that (i) the effect of population aging of workforce varies depending on a driving force of population aging and (ii) the effect of expectation formation is non-monotonic across ages and the largest in a middle-age cohort. Also, we analyze uncertainty about future trade liberalization. Then, we show that (iii) the mechanism cannot work due to strategic delay, but (iv) a subsidy scheme or political leadership can resolve this problem.

Memory, market stability and attractors coexistence in a nonlinear cobweb model

We investigate the dynamics of a cobweb type model with nonlinear demand and supply curves in which producers make forecasts on future prices with a backward looking expectation formation mechanism: the expected price for the next period is obtained by a weighted average of the prices observed in the last two periods. The study herewith presents aims at confirming the existence of a locally stabilising effect due to the presence of memory, but an increase of memory in price expectations can be globally qualitatively destabilising, in the sense that it leads to coexistence of different attractors with their respective basins of attraction.

A Cobweb Model with Alternating Demand and Supply Functions

In this work I present a cobweb model for markets characterized by two couples of demand and supply functions which cyclically alternate with period two, in a succession of peak and off-peak market phases. Starting from classical adaptive expectations, a new expectation formation mechanism is presented, to take into account such markets’ peculiarity. In particular, to adapt the previous in-phase expected price, agents use both in-phase and out-of-phase expectation errors, suitably weighted through a phase weight. It is shown that the resulting model is described by a non-autonomous difference equation. The local asymptotic stability of the steady state equilibrium is studied, showing that it depends on the expectation weight, the phase weight and on both the relative slopes, at the equilibrium, of the supply functions with respect to the demand functions. Several crucial differences with respect to the classical cobweb model are highlighted, showing the potentially ambiguous role of expectation weight and of relative slopes. It is shown that destabilization can occur both through a flip and a Neimark-Sacker bifurcation, which can occur for the same market conditions and different expectation weights.

Equilibrium and Disequilibrium Dynamics in Cobweb Models with Time Delays

This paper aims to study price dynamics in two different continuous time cobweb models with delays close to [Hommes, 1994]. In both cases, the stationary equilibrium may be not representative of the long-term dynamics of the model, since it is possible to observe endogenous and persistent fluctuations (supercritical Hopf bifurcations) even if a deterministic context without external shocks is considered. In the model in which markets are in equilibrium every time, we show that the existence of time delays in the expectations formation mechanism may cause chaotic dynamics similar to those obtained in [Hommes, 1994] in a discrete time context. From a mathematical point of view, we apply the Poincaré–Lindstedt perturbation method to study the local dynamic properties of the models. In addition, several numerical experiments are used to investigate global properties of the systems.

Noncausality and Asset Pricing

Misspecification of agents' information sets or expectation formation mechanisms may lead to noncausal autoregressive representations of asset prices. Annual US stock prices are found to be noncausal, implying that agents' expectations are not revealed to an outside observer such as an econometrician observing only realized market data. A simulation study shows that noncausal processes can be generated by asset-pricing models featuring heterogeneous expectations.

Noncausality and asset pricing

Misspecification of agents’ information sets or expectation formation mechanisms may lead to noncausal autoregressive representations of asset prices. Within the class of linear (vector) autoregressions, annual US stock prices are found to be best described by noncausal models, implying that agents’ expectations are not revealed to an outside observer such as an econometrician observing only realized market data. A simulation study shows that noncausal asset prices are observed when the data are generated by asset-pricing models featuring heterogeneous expectations.

Monetary Policy with Heterogeneous and Misspecified Expectations

In the recent literature on monetary policy and learning, it has been suggested that private sector's expectations should play a role in the policy rule implemented by the central bank, as they could improve the ability of the policymaker to stabilize the economy. Private sector's expectations, in these studies, are often taken to be homogeneous and rational, at least in the limit of a learning process. In this paper, instead, we consider the case in which private agents are heterogeneous in their expectations formation mechanisms and hold heterogeneous expectations in equilibrium. We investigate the impact of this heterogeneity in expectations on central bank's policy implementation and on the ensuing economic outcomes, and the general result that emerges is that the central bank should disregard inaccurate private sector expectations and solely base its policy on the accurate ones.

Profitability of Expectation Based on Trading Rules: A Study on Kuwait Stock Market

This paper provides empirical evidence on the profitability of the alternative expectation formation mechanisms in the case of Kuwait Stock Exchange as an example of an emerging market. The results indicate that both extrapolative and adaptive expectations are profitable while regressive expectations are not. In addition, the results imply that extrapolative expectations are more profitable than adaptive. An important conclusion of this paper is that the market suffers form inefficiency since future trend of the market can be predicted from its past performance, a phenomenon shared by emerging markets.