A New Keynesian Model with Heterogeneous Expectations

This paper introduces heterogeneous expectations into a New Keynesian model. Our primary theoretical contribution is to provide an aggregation result for a model with nominal rigidities and heterogeneous bounded rationality. We incorporate bounded rationality at the individual agent level and determine restrictions on expectations operators sufficient to imply aggregate IS and AS relations of the same functional form as those under rationality. This comparability allows for explicit analysis of the impact of heterogeneity on the model’s dynamics. As an example, we consider a case where a fraction of agents are rational and the remainder are adaptive. We show that incorporating heterogeneous expectations into the New Keynesian model may significantly alter the determinacy properties: models that are determinate under the assumption of rationality may possess multiple equilibria in the presence of expectations heterogeneity, even for small departures from rationality. JEL Classifications: E52; E32; D83; D84