Misperceptions, heterogeneous expectations and macroeconomic dynamics

We investigate the extent to which misperceptions about the economy can become self reinforcing and thereby contribute to time-varying macroeconomic dynamics. To do so, we build a New Keynesian model with long-horizon expectations and dynamic predictor selection. Because agents solve multiperiod optimisation problems (households maximise expected lifetime utility and …rms maximise the discounted ‡ow of future pro…ts), their current decisions are in‡uenced by expectations of the in…nite future and cannot in general be characterised by the Euler equations that typically represent the rational expectations equilibrium of these models. We assume that agents have access to a set of alternative predictors that can be used to form expectations. Agents choose among these predictors based on noisy measures of their recent performance. This dynamic predictor selection generates endogenous ‡uctuations in the proportions of agents using each predictor, contributing to macroeconomic dynamics. We explore the behaviour of our model when agents have access to two simple predictors, one of which is consistent with a mistaken belief that macroeconomic variables are more persistent. We show that the presence of a ‘persistent predictor’can lead to changes in beliefs which are self reinforcing, giving rise to endogenous ‡uctutions in the time series properties of the economy. Moreover, we show that such ‡uctuations arise even if we replace the ‘persistent predictor’with learning under constant gain. This paper is preliminary and incomplete –please do not quote without the authors’permission. The views expressed in this paper are those of the authors and not necessarily those of the Bank of England. We would like to thank Charlie Bean, Cars Hommes and Peter Sinclair for useful discussions on earlier versions of this paper. All errors are ours.