Near-Rational Exuberance

We study how the use of judgement or “add-factors” in macroeconomic forecasting may disturb the set of equilibrium outcomes when agents learn using recursive methods. We isolate conditions under which new phenomena, which we call exuberance equilibria, can exist in standard macroeconomic environments. Examples include a simple asset pricing model and the New Keynesian monetary policy framework. Inclusion of judgement in forecasts can lead to self-fulfilling fluctuations, but without the requirement that the underlying rational expectations equilibrium is locally indeterminate. We suggest ways in which policymakers might avoid unintended outcomes by adjusting policy to minimize the risk of exuberance equilibria. JEL codes: E520, E610. ∗Email: [email protected]. Any views expressed are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of St. Louis or of the Federal Reserve System. †Email: [email protected]. ‡Email: [email protected]. §We thank Roger Farmer for comments on an early version.