Business cycle amplification with heterogeneous expectations

Abstract

This paper studies the implications for business cycle dynamics of heterogeneous expectations in a stochastic growth model. The assumption of homogeneous, rational expectations is replaced with a heterogeneous expectations model where a fraction of agents hold rational expectations and the remaining fraction adopt parsimonious forecasting models that are, in equilibrium, optimal within a restricted class. Our approach nests the literature on rational expectations in business cycle models with a recent approach based on adaptive learning. We demonstrate that (i.) heterogeneous expectations can lead to substantial improvement in the internal propagation of equilibrium business cycle models and (ii.) the internal propagation depends on the degree of heterogeneity. A calibrated model with heterogeneity provides a closer fit to business cycle data than its representative agent, rational expectations counterpart.

Cowboying Stock Market Herds with Robot Traders

“…Therefore, increasing agents' diversity of beliefs about the fundamental value of the stock is likely to dampen the destabilizing herding effects coming from their imitative behavior. Such a result is in contrast to a growing volume of literature where the diversity of beliefs is found to generate endogenous volatility in the absence of local interactions (see, e.g., Kurz, 1994;Brock and Hommes, 1998;Kurz et al, 2005;Branch and McGough, 2011). Hence, our analysis suggests that the effects of heterogeneous beliefs on volatility can be conditioned by the underlying assumptions on how agents interact, though we were not able to disentangle these features.…”

Monetary Policy in a Non‐representative Agent Economy: A Survey

“…Finally, Branch and McGough () consider dynamic predictor selection within the New Keynesian model with heterogeneous expectations. They extend their earlier framework (Branch and McGough, ) by incorporating endogenous movements in the shares of predictors along the lines of Brock and Hommes ().…”

“…Motolese, 2001Motolese, , 2003. Also Branch and McGough (2011) investigate the implications of heterogeneous expectations for business cycle dynamics. Within a stochastic growth model, where a fraction of agents forms rational expectations and the remaining ones employ more parsimonious forecasting models (therefore, a fraction of agents is rationally bounded), authors demonstrate that heterogeneous expectations can lead to a substantial improvement in the internal propagation of the business cycle.…”

Monetary Policy in a Non-Representative Agent Economy: A Survey

“…Motolese, 2001Motolese, , 2003. Also Branch and McGough (2010a) investigate the implications of heterogeneous expectations for business cycle dynamics. Within a stochastic growth model, where a fraction of agents forms rational expectations and the remaining ones employ more parsimonious forecasting models (therefore, a fraction of agents is rationally bounded), authors demonstrate that heterogeneous expectations can lead to a substantial improvement in the internal propagation of the business cycle.…”