Learning and Excess Volatility

We introduce adaptive learning behavior into a general equilibrium lifecycle economy with capital accumulation. Agents form forecasts of the rate of return to capital assets using least squares autoregressions on past data. We show that, in contrast to the perfect foresight dynamics, the dynamical system under learning possesses equilibria characterized by persistent excess volatility in returns to capital. We explore a quantitative case for these learning equilibria. We use an evolutionary search algorithm to calibrate a version of the system under learning and show that this system can generate data that matches some features of the time series data for U.S. stock returns and per capita consumption. We argue that this finding provides support for the hypothesis that the observed excess volatility of asset returns can be explained by changes in investor expectations against a background of relatively small changes in fundamental factors. JEL Classifications: C62, D83, G12 James Bullard Research Department Federal Reserve Bank ofSt. Louis 411 Locust Street St. Louis, MO 63102 (314) 444-8576 [email protected] John Duffy Department ofEconomics University of Pittsburgh Pittsburgh, PA 15260 (412) 648-1733 jduffy+ @ pitt.edu LEARNING AND EXCESS VOLATILITY 1