Rational Expectations Framework Research Articles

Jump–diffusion productivity models in equilibrium problems with heterogeneous agents

In this paper we adopt a rational expectations framework to formulate general equilibrium models with heterogeneous agents. The productivity dynamics are characterized by a jump–diffusion model, thus allowing to account for sudden and impactful events. The modelling approach utilizes Hamilton–Jacobi–Bellman (HJB) formulations to represent the endogenous decision-making of firms to remain or exit the industry. When firms decide to exit, they are instantaneously replaced by new entrants. This dynamic leads to the development of a probability density function for firms, which satisfies a Kolmogorov–Fokker–Planck (KFP) equation with a source term. Both HJB and KFP formulations involve partial-integro differential operators due to the presence of jumps. Equilibrium models are completed with the household problem and feasibility conditions. Since (semi-)analytical solutions are not available, a numerical methodology is considered. This approach involves a Crank–Nicolson scheme for the time discretization, an augmented Lagrangian active set method and a finite difference discretization for the HJB formulation, and an appropriate finite difference method for the KFP problem. Moreover, Adams–Bashforth schemes are employed to handle integral terms explicitly. For the global equilibrium problem, we introduce a Steffensen algorithm. Numerical examples are provided to showcase the performance of our proposed numerical methodologies and to illustrate the expected behaviour of computed economic variables.

A Dynamic CGE Model for Optimization in Business Analytics: Simulating the Impact of Investment Shocks

This study formulates a mathematical dynamic Computable General Equilibrium (CGE) model within a rational expectations framework, adhering to neo-classical principles. It emphasizes the significant role of agents’ expectations in determining the broader economic trajectory over time. The model combines microeconomic and macroeconomic perspectives by merging the concept of intertemporal choice with savings behavior. Its mathematical foundations are derived and calibrated using data from a social accounting matrix to enhance its simulation capabilities. The paper presents a practical simulation investigating the economic implications of a strategic investment impact within an specific European region, Madrid as the case of study. Such demand shock affects sectors such as electronics, food, pharmaceuticals, and education. The study models the long-term effects of heightened investment and persistent demand-side shocks. The research demonstrates the CGE model’s ability to forecast economic shifts toward a new equilibrium after an investment shock, proving its utility for assessing the impacts of extensive environmental policies within a European context. The work’s originality lies in its detailed mathematical formulation, contributing to theoretical discourse and practical application in business analytics.

What do we know about the value and market impact of the US Department of Agriculture reports?

AbstractThe purpose of this paper is to comprehensively review the literature on the value and impact of the US Department of Agriculture (USDA) reports and discuss theoretical issues and empirical evidence. Only a handful of studies provide direct estimates of the welfare benefits of USDA information using a rational expectations framework in storable commodity markets. Most studies examine partial evidence of welfare benefits associated with market response to USDA information. These studies include examinations of the impacts of USDA report releases on cash and futures price volatility and other market dynamics, impacts of report releases on options implied volatility, impacts of unanticipated information in USDA reports, as well as informational value, returns, and survey‐based studies. We discuss the methodological and empirical contributions of these studies as well as their shortcomings and potential opportunities for future work.

Bonds, Currencies and Expectational Errors

We propose a model in which sticky expectations concerning short-term interest rates generate joint predictability patterns in bond and currency markets. Our parsimonious specification can explain the downward sloping term structure of carry trade returns, difficult to replicate in a rational expectations framework. We offer empirical support for our approach and show that including a sticky short rate expectations channel into a standard affine term structure allows the model to better capture the drift patterns in the data.

Information and volatility linkages between real estate, equity, bond and money markets in Australia

PurposeThe purpose of this paper is to examine information and volatility linkages among real estate, equity, bond and money markets in Australia.Design/methodology/approachA novel rational expectations framework of financial contagion (Kodres and Pritsker, 2002), along with a combination of robust statistical methods including simple and dynamic correlations and generalized impulse response (Fereidouni et al., 2014) have been employed using data covering three dynamic pre-pandemic economic cycles, namely, global financial crisis (GFC) period, pre-pandemic housing boom and pre-pandemic housing downturn from 2008 (February) to 2019 (December).FindingsResults reveal information linkages across real estate, equity, bond and money markets through correlations in return and volatilities of these series. Finding indicates that the three financial markets (equity, bond and money markets) are interdependent and integrated through information and volatility linkages during the GFC period and pre-pandemic housing downturn period. Financial markets have stronger associations with real estate market during pre-pandemic housing boom. The findings contribute to the general notion that the performances of three financial markets are closely related to the “boom” phase of the real estate cycle.Originality/valueThis research provides an extension of existing literature regarding the information and volatility contagion of the expanded set of core investment markets in Australia. The findings could assist household buyers and investors in designing strategic investment portfolios/hedging strategies and minimizing asset specific risks through diversification over short-term and long-term. In addition, results could support the maintenance, growth and development of a combination of competitive balanced investment markets including real estate, equity, bond and money markets in post-pandemic economy.

Multidimensional noise and non-fundamental information diversity

This paper relaxes the common assumption of the standard competitive noisy rational expectations framework that noise is one-dimensional. Within an environment characterized by multidimensional noise, I explore the strategic interactions between different traders that are informed about different components of the noise inherent in the market price. If noise is two-dimensional, several new types of complementarities in traders’ interactions arise that cannot be studied in the classical one-dimensional framework. The higher-dimensional case uncovers that higher dimensionality of noise mitigates the possibility of a market breakdown by weakening adverse selection. On the basis of the theoretical results, I discuss some predictions and implications concerning the effects of the increased usage of “payment for order flow” in financial markets.

The marginalization of absolute and relative income hypotheses of consumption and the role of fiscal policy

Contrary to Keynes’ and Duesenberry’s consumption theories, absolute or relative income plays a minimal role in the life-cycle and in the permanent-income hypotheses. It plays an even lesser role in contemporary orthodox consumption functions which are extensions of these two theories in a rational-expectations framework. As a result, the theoretical effectiveness of fiscal policy for raising output is greatly diminished. The paper argues that Keynes’ and Duesenberry’s approaches were marginalised not because of their empirical or theoretical shortcomings, but because of emphasising the psychological and social influences on consumption patterns, and because of not employing the intertemporal utility maximising framework.

Inflation, Monetary Policy and Monetary Aggregates

Taxonomically speaking, the received theories of the macroeconomy may be said to comprise monetarism, structuralism, Marxism, the post-Keynesian view and the New Consensus Macroeconomics (NCM). However, in the last few decades, the mainstream view has been converging on the NCM, representing a grafting of essentially Keynesian ideas on a framework of rational expectations. Associated with this consensus has been a steady de-emphasis on the role of monetary aggregates in the framing of monetary policy. This paper is devoted to an examination of the role of monetary aggregates in each of the macroeconomic theories listed above. In particular, it contests the prevailing mainstream policy viewpoint (heavily influenced by the NCM) that monetary aggregates have no explanatory power for inflation beyond that contained in the output gap. On the contrary, the empirical fact that several monetary shocks originate on the supply side, coupled with the strong possibility of monetary shocks affecting output through relative price changes, make out a strong case for the inclusion of monetary aggregates at least as a Second Pillar of monetary policy (in the manner currently done at the European Central Bank). A monetary policy calibrated without reference to monetary aggregates is like Hamlet without the Prince of Denmark.

Do central banks respond to exchange rate movements? A Markov-switching structural investigation of commodity exporters and importers

We analyse whether central banks in small open commodity exporting and importing countries respond to exchange rate movements, taking into consideration that there may be structural changes in parameters and volatility. Using a Markov Switching Rational Expectations framework, we estimate the model for Australia, Canada, New Zealand, Norway, Sweden and the UK. We find that the size of policy responses, and the volatility of structural shocks, have not stayed constant over the estimation sample. Furthermore, monetary policy has responded strongly to the exchange rate for many commodity exporters, most notablyNorway. This has had a stabilizing effect on the exchange rate. In particular, although the terms of trade are highly volatile among commodity exporters, the exchange rate has about the same volatility across all importers and exporters in the recent period. • Analyse if central banks in commodity exporters and importers respond to the exchange rate, allowing for time-varying policy rule and shocks. • Find strong evidence that neither policy responses nor the volatility of structural shocks have remained constant. • Central banks in three commodity exporting countries, Canada, New Zealand and Norway, respond strongly to the exchange rate in periods. • For Norway, the central bank also responds strongly to the exchange rate after adopting inflation targeting. • Policy rules with a high response to the exchange rate exacerbate the effects of external shocks on the domestic variables in advanced economies.

Feedback Trading and Bubbles

The paper develops a model of bubbles that can be taken to the data and explain the behavior of asset prices and their statistics. We depart from the rational expectations framework and assume that investors are only boundedly rational. They observe the price process, but do not fully understand how its volatility and expected returns are determined in equilibrium. Investors learn about the market by looking at past prices. When they observe unexpectedly high returns, they infer that the asset must currently have a high Sharpe ratio, and therefore, allocate a higher share of their wealth to the asset, further increasing the asset price. The interaction of this feedback effect with investors' wealth effect determines the price dynamics and evolution of investors' beliefs in the model. We fit the model to cryptocurrency markets and show that it can successfully explain many empirical facts in these markets.

Operations strategies with snobbish and strategic consumers

AbstractStudying the optimal production and pricing strategies of a luxury brand manufacturer (in this paper, the “manufacturer” is in fact also the “retailer”), we consider the following situation. First, consumers exhibit a prestige‐seeking (snobbish) behavior that values product exclusivity. Their utility decreases as more consumers possess the product. Second, consumers show a forward‐looking (strategic) behavior. They make shop visit decisions based on predicted product availability. Third, the manufacturer's production policy is unobservable to consumers. Given these basic premises, we consider a traditional newsvendor inventory system and analytically derive the equilibrium production and pricing strategies within the rational expectation framework. We then propose two improvement strategies, each using a well‐established channel policy, to steer the game participants to reach a better equilibrium than the one for the traditional system. First, under the limited edition strategy with consumer returns, the firm uses the consumer return policy as a proxy for the limited edition strategy that aims to increase product exclusivity. Second, under the product line extension strategy, the firm applies product line extension as a means to guide the game participants to simultaneously increase product availability and product exclusivity. Finally, we extend the study by incorporating a variety of modeling variations and examine robustness of the research findings.

Information linkages among National, NSW, VIC, and QLD real estate markets in Australia

AbstractWe examine information and volatility linkages among NATIONAL, NSW, VIC and QLD housing markets in Australia using the novel rational expectations framework of financial contagion and a combination of robust econometric methods including the Generalised Method of Moments (GMM), correlations and Generalised Impulse Response Method, etc. We find information linkages across markets are revealed in the correlations of their volatilities and correlations of the house price returns. Moreover, we find these volatilities reflect house price patterns of the most important four real estate economic cycles over the last two decades.

Are high–frequency traders informed?

Are high–frequency traders (HFTs) informed? To address this question, we examine HFTs' activity in the call auction environment, where speed-related trading is limited and signal processing capacity becomes more relevant. To model the call market, we consider the Kyle (1989) rational expectations framework for strategic trading. The test we propose for detecting informed HFTs in this market assesses potential deviations of the informativeness of HFTs' aggregate (net) demand, from the informativeness of the aggregate demand submitted by the rest of the traders. Data from the Euronext Paris preopening phase indicate that informed HFTs are present in the market just before the opening. Our results provide useful guidance for the assessment of the influence of HFTs’ quotes on price quality, an important issue for market regulators and policy makers.

Diverse Non-Fundamental Information and Trading Complementarities

In this paper, I relax the common assumption of the one-dimensionality of noise made in the standard noisy rational expectations framework. Within an environment characterized by multidimensional noise, I explore the strategic interactions between different traders that are informed about different components of the noise inherent in the market price. I find that agents' trades against different types of noise are complements due to a reduction in uncertainty about fundamentals initiated by more aggressive trading. Strategic complementarities can also be found in the information market. Both acquiring information about the same type and about different types of noise can be complements

Mutual Funds: Skill and Performance

The authors summarize the recent literature on mutual fund manager skill and performance. They discuss the latest contributions in the field and reinterpret them through the lens of the rational expectations framework (efficient market hypothesis). They further discuss the importance of (1) the choice of benchmark model and (2) the time-series and cross-sectional sample selected in performance studies. The article has three main conclusions. First, although net alpha is a measure of the abnormal return of an extra dollar invested in a particular fund (i.e., performance), it does not measure mutual fund manager skill. To measure the latter, the product of gross alpha and the size of the fund—value added—is needed. Second, the set of real-time available index funds is the relevant counterfactual to use when assessing the skill and performance of investment managers. Nontradable factors that are constructed with the benefit of hindsight are not a realistic benchmark. Third, the authors can think of no good reason to exclude high-quality mutual fund data either in the cross section or time series when making inferences regarding skill and performance. <b>TOPICS:</b>Manager selection, mutual fund performance, performance measurement <b>Key Findings</b> • Net alpha is not an appropriate measure of mutual fund manager skill; value added, the product of assets under management and gross alpha, is a measure of mutual fund manager skill. • The set of real-time available index funds is the relevant counterfactual investment opportunity set for assessing skill and performance of investment managers. • Studies of skill and performance should not exclude high-quality data on mutual funds from either the cross section or the time series.

Bonds, Currencies and Expectational Errors

We propose a model in which sticky expectations concerning short-term interest rates generate joint predictability patterns in bond and currency markets. Using our calibrated model, we quantify the effect of this channel and find that it largely explains why short rates and yield spreads predict bond and currency returns. The model also creates the downward sloping term structure of carry trade returns documented by Lustig et al. (2019), difficult to replicate in a rational expectations framework. Consistent with the model, we find that variables that predict bond and currency returns also predict survey-based expectational errors concerning interest and FX rates. The model explains why monetary policy induces drift patterns in bond and currency markets and predicts that long-term rates are a better gauge of market’s short rate expectations than previously thought.

Unraveling Momentum's Moments

I examine the momentum anomaly through the prism of higher order risk neutral moments of high and low momentum stocks. I use option prices from 2002 to 2013 to extract time varying ex ante estimates of variance, skewness and kurtosis of high and low momentum stocks. High momentum stocks have lower variance, less negative skewness and lower kurtosis. This is in contrast to studies that use static, ex post estimates of skewness to explain momentum returns as a function of exposure to the higher order moments of the underlying return distribution. These results highlight that momentum returns can not be explained by ex ante estimates of higher order moments and remain dicult to resolve empirically in a rational expectations framework.

Monetary-fiscal policies interactions and optimal rules in Egypt

Purpose This paper aims to estimate a New Keynesian small open economy dynamic stochastic general equilibrium (DSGE) model for Egypt using Bayesian techniques and data for the period FY2004/2005:Q1-FY2015/2016:Q4 to assess monetary and fiscal policy interactions and their impact on economic stabilization. Outcomes of monetary and fiscal authority commitment to policy instruments, interest rate, government spending and taxes, are evaluated using Taylor-type and optimal simple rules. Design/methodology/approach The study extends the stylized micro-founded small open economy New Keynesian DSGE model, proposed by Lubik and Schorfheide (2007), by explicitly introducing fiscal policy behavior into the model (Fragetta and Kirsanova, 2010 and Çebi, 2011). The model is calibrated using quarterly data for Egypt on key macroeconomic variables during FY2004/2005:Q1-FY2015/2016:Q4; and Bayesian methods are used in estimation. Findings The results show that monetary and fiscal policy instruments in Egypt contribute to economic stability through their effects on inflation, output and debt stock. The monetary policy Taylor rule estimates reveal that the Central Bank of Egypt (CBE) attaches significant importance to anti-inflationary policy and (to a lesser extent) to output targeting but responds weakly to nominal exchange rate variations. CBE decisions are significantly influenced by interest rate smoothing. Egyptian fiscal policy has an important role in output and government debt stabilization. Additionally, the fiscal authority chooses pro-cyclical government spending and counter-cyclical tax policies for output stabilization. Again, past values of the fiscal instruments are influential in the evolution of the future fiscal policy-making process. Originality/value A few studies have examined the interaction between monetary and fiscal policy in Egypt within a unified framework. The presented paper integrates the monetary and fiscal policy analysis within a unified dynamic general equilibrium open economy rational expectations framework. Without such a framework, it would not be easy to jointly analyze monetary and fiscal transmission mechanisms for output, inflation and debt. Also, it would be neither possible to contrast the outcome of monetary and fiscal authorities commitment to a simple Taylor instrument rule vis-à-vis optimal policy outcomes nor to assess the behavior of monetary and fiscal agents in macroeconomic stability in context of an active/passive policy decisions framework.

Walk on the Wild Side: Temporarily Unstable Paths and Multiplicative Sunspots

We propose a generalization of the rational expectations framework to allow for temporarily unstable paths. Our approach introduces multiplicative sunspot shocks and it yields drifting parameters and stochastic volatility. Then, we provide an econometric strategy to estimate this generalized model on the data. The methodology allows the data to choose between different possible alternatives: determinacy, indeterminacy, and temporary instability. We apply our methodology to US inflation dynamics in the 1970s through the lens of a simple New Keynesian model. When temporarily unstable paths are allowed, the data unambiguously select them to explain the stagflation period in the 1970s. (JEL D84, E12, E31, E32, E52)

Returns to Scale Among Corporate Bond Mutual Funds

I document a (within-fund) hump-shaped relation between fund size and subsequent fund performance among U.S. corporate bond mutual funds. When funds are small, they exhibit increasing returns to scale but when they become large, they exhibit decreasing returns to scale. This sharply contrasts with the previous finding of decreasing returns to scale among equity mutual funds. Further, I show that the nature of trading cost in the corporate bond market --- in particular, a U-shaped relation between trade size and unit trading cost at the corporate bond level --- is relevant for explaining hump-shaped returns to scale. Interpreting these empirical patterns is not straightforward, though. In a rational expectations framework, we expect a fund's net alpha always to be zero and hence, no time-series relation between fund size and subsequent fund alpha. To help interpret the empirical findings, I propose a dynamic model in which investors learn about a fund's ability to manage its trading cost from its past returns. The evolution of investors' beliefs provides a source of variation in fund size and further, in fund alpha in equilibrium over time.