INEXC - International Network on Expectational Coordination

About INEXC

In spite of an intense academic activity over previous decades, the current crisis suggests that economic theory has failed to provide an appropriate global understanding of the recent events. Two key assumptions underlying most existing theories have been rightly questioned:

One group of critics has proposed that agents in financial markets are less rational than has been assumed in most economists’ models. Departures from the standard paradigm of rationality constitute the substance of what has come to be known as behavioural economics. Integrating behavioural economics into finance is clearly a promising avenue for research.
A second group of critics questions the “rationality of expectations”. The Rational Expectations Hypothesis (REH) assumes that economic agents have an unbiased, statistically correct, view of the future. REH is not a consequence of the classic Rationality Hypothesis, nor is the standard Rationality Hypothesis a necessary ingredient of models fitting REH (Non-expected utility maximizers may be given rational expectations). Hence this second axis is conceptually distinct and broadly independent of the first one.

The project presented here focuses on the critique of REH, a critique which applies to many areas of analysis, notably the study of financial markets and the study of macroeconomics. Indeed, most theories in finance, as well as in macroeconomics, have tended to adopt REH axiomatically. We believe that REH, in its standard version, is a key ingredient of the excessive optimism that economic theory currently conveys regarding the working of the financial system. This excessive optimism has fuelled the excessive confidence in the self regulating capabilities of the system, which, as is now argued by many, is at the heart of its recent failures.

Nodes & Fellows

The nodes, members, previous work and new directions…

Amsterdam node

Leader: Cars H. Hommes
In this node of University of Amsterdam, CeNDEF, the main subject of entry into the network’s program is the experimental validation of Coordination of heterogeneous expectations. In particular, we will focus on using laboratory experiments with human subjects to study expectation coordination and to validate different expectations hypotheses and learning models.

Individual expectations about future economic variables, such as asset prices or inflation, play an important role in real life as well as in economic theory. Expectations shape the decisions of individuals and, hence, affect the realization of aggregate variables. In turn, these realizations may affect individual expectations. In this way one may think of an economy as an expectation feedback system. A standard approach to modelling agents’ expectations has been to assume rational expectations, when market participants form model-consistent predictions of future outcomes, as if they have full knowledge of the economic law of motion. However, the rational expectation models are not satisfactory, neither in their predictions nor in their unrealistic assumptions of perfect rationality. For example, the strong recent decline of financial markets and the current economic crises are hard to reconcile with the rational model. Moreover, non-rational, heterogeneous expectations are frequently found in laboratory experiments as well as in survey data.

There are many alternatives to assuming rational expectations, but typically the predictions of these models critically depend upon which expectation rules are assumed. Deviating from the rational expectations hypothesis gives many degrees of freedom in modeling expectation formation. In order to discipline this so-called “wilderness of bounded rationality’’ (Sims, 1980) we will study, by running laboratory experiments with paid human subjects, how individuals form expectations, whether or not these individual expectations are coordinated and what is the resulting aggregate behavior in the economy.

Indeed, laboratory experiments with human subjects, where the experimenters have full control over the market environment and economic fundamentals, form an ideal tool to study individual expectations and how their interaction shapes aggregate market outcomes. For example, in experimental asset markets (e.g. Smith et al., 1988) bubbles and crashes in asset prices may arise. It has been suggested that these non-equilibrium phenomena emerge due to the lack of common knowledge of rationality.

While in earlier experimental work expectations often played an indirect role and their formation and effects were not easy to test, more recently, so-called learning-to-forecast experiments (LtFEs) have been designed to study the expectation formation process directly. In these LtFEs (see Hommes, 2011 for an overview), a subject’s only task is to forecast e.g. the price of some asset, for a number, say 50-60, of periods, with the realization of aggregate economic variables in each period determined by (average) individual expectations. LtFEs thus provides clean data on individual expectations as well as aggregate price behavior.

One of the most striking phenomena found in a number of these LtFEs is the coordination of individual expectations: after a short learning phase subjects submit very similar predictions, despite being uninformed about past and current predictions of the others participants, see e.g. Hommes et al. (2005). Moreover, estimation of individual prediction rules suggests (see e.g. Hommes et al., 2005, Heemeijer et al., 2009, and Assenza et al., 2010) that participants often use simple, behavioral rules, where some participants use adaptive expectations, while others extrapolate trends in past prices. Coordination of expectations also depends upon the nature of the expectations feedback structure. Heemeijer et al. (2009), for example, run LTFEs with two perfectly symmetric treatments, one where the feedback between predictions and the realized price is positive, and one where it is negative. In the latter case participants learn to coordinate on the rational expectations equilibrium quickly. In contrast, in the positive feedback treatment, participants also coordinate their expectations but not on the rational expectations equilibrium, leading to persistent deviations from fundamental values. Similar results have been found in Fehr and Tyran (2008), Sutan and Willinger (2009) and Sonnemans and Tuinstra (2010).

Laboratory experiments are very useful for testing different models of expectation formation. Anufriev and Hommes (2009) and Anufriev et al (2010) show that a model of heterogeneous, dynamically evolving expectations, the so-called Heuristic Switching Model (HSM), fits the data from LtFEs nicely. Neither the rational expectations model nor other homogeneous expectations models (e.g., adaptive or trend-following expectations) outperform the HSM. The HSM is successful in explaining coordination of individual expectations across different market settings.

In this node we will run new LtFEs in a number of different finance and macro-economic environments, such as asset pricing models, overlapping generation models and New Keynesian macro-economic settings. We will use the data from these LtFEs to address the following important questions. (i) How do individuals form expectations? (ii) Will coordination of expectations occur, even when there is limited information, or will heterogeneity persist? (iii) When does learning enforce convergence to rational expectations equilibria and when do boundedly rational “learning equilibria” arise? Moreover, the new experiments will provide additional empirical evidence that we will use to improve the fit of the HSM, and to test the model for robustness with respect to the experimental environment. The HSM model will also be tested on empirical time series, e.g., stock prices and inflation. Finally, we will use the experimental data to organize a competition between different theories of expectations and learning and investigate which theory fits the data most accurately.

Paris node

Leader: Roger Guesnerie
The Paris node is not working too hard, as it is well known the French take a lot of vacation and time off (https://www.vacances-scolaires-gouv.com/2022-2023-calendrier-scolaire) . Holidays are sacred for them, so work is more in the background than anything, while vacation research takes up most of their time. Vive la France!

Members

Mikhail Anufriev
Tiziana Assenza
Te Bao
Cees Diks
Cars H. Hommes
Jan Tuinstra
Florian Wagener

Barcelona node

Leader: Ramon Marimon
The members of the Barcelona node of the Project on “Expectational Coordination and Financial Markets” are members – or associated with – the Barcelona Graduate School of Economics. There are two main areas of research. Klaus Adam (Manheim University), Gaetano Gaballo (European University Institute, joining the Banque de France, Fall 2011), Albert Marcet (London School of Economics, joining the Institute of Analisi Economica -CSIC and BarcelonaGSE, Fall 2011) and Ramon Marimon (European University Institute and BarcelonaGSE – UPF) research is on expectations and learning in macroeconomics and finance. Empirical implications and policy design when subjective and objective beliefs may not coincide; the role of imperfect information about others’ beliefs in generating non-fundamental business fluctuations; explaining expectations-driven boom and bust cycles of asset prices with rationally investing agents; the role of competition in enhancing coordination of beliefs and innovation. Antoni Bosch-Domenech (Universitat Pompeu Fabra and BarcelonaGSE), jointly with Nagore Iriberri and Rosemarie Nagel, studies experimentally the formation of beliefs and expectations in coordination games with strategic complements or substitutes.

Members

Klaus Adam
Albert Marcet
Ramon Marimon

Chile node

Leader: Alejandro Jofre
The research node coordinated in Santiago is an active and strong group working on Variational Analysis, decision models under uncertainty, stochastic optimization, dynamic and stochastic equilibrium, dynamic contract theory, computational economics and quantitative risk analysis. We have a long scientific cooperation with U. Washington and U. California. Areas of application include financial mathematics, electricity and telecommunication markets, portfolio management, reliability and optimal control. Researchers from the Center of Mathematical Modeling, departments of Economics, Industrial Engineering of Universities of Chile, Catolica and Santiago, and the Central Bank will be involved in this initiative.

The researchers of this node have recent contributions on dynamic and stochastic equilibrium in the framework of incomplete/financial markets, expectational coordination, and stochastic and global games with applications to energy, telecommunication and dynamic contract/behavioral theory.

Some recent references:

A. Jofre, R.T. Rockafellar and R. Wets. A time-embedded approach to economic equilibrium with incomplete financial markets. Advances in Mathematical Economics, 14 (2011), 183-196.
A. Jofre, R.T. Rockafellar and R. Wets… General economic equilibrium with incomplete markets and money. Submitted (2010) Econometrica.
Roger Guesnerie and Pedro Jara-Moroni. Expectational coordination in simple economic contexts Concepts and analysis with emphasis on strategic substitutabilities. To appear in Economic Theory (2011).
U. Doraszelski, J. F. Escobar. A theory of regular Markov perfect equilibria in dynamic stochastic games: Genericity, stability, and purification. Theoretical Economics 5 (2010), 369–402.
Jofre, Alejandro; Rockafellar, Terry; Wets, Roger. Variational Inequalities and economic equilibrium. Mathematics of Operation Research, Vol. 32 (2007), pp. 3250.
R. T. Rockafellar, S. Uryasev and M. Zabarankin. Equilibrium with investors using a diversity of deviation measures,” Journal of Banking and Finance 31 (2007), 3251-3268.

Members

Juan Escobar
Rodrigo Harrison
Pedro Jara
Alejandro Jofre
Terry Rockafellar
Roger Wets

China node

Leader: Ho-Mou Wu
The Chinese Node will be expanded in the future to include serious scholars in China and in the East Asian Area (except Japan) who are interested in the proposed direction of research. It currently consists of three scholars: Ho-Mou Wu (Peking University, Beijing, China); Jianguo Xu (Peking University, Beijing, China); Wen-Chung Guo (National Taipei University, Taipei, Taiwan).

Past research of this group has covered the formalization of the concept of endogenous uncertainty with a focus on its implications for financial markets, including the resultant market volatility, asset price properties and corporate finance issues with diverse beliefs. The thrust of our research breaks away from the rational expectation framework where the agents are assumed to know at each date the map between future exogenous states and future commodity and security prices.

We focus on three aspects of the new direction. Firstly, we continue developing the content of endogenous uncertainty. A particular focus is to make the future prices to be dependent on both future states and future belief structures. The endogenously formed beliefs thus cause the future prices to fluctuate beyond the influence of the future states. Such an additional dimension of uncertainty is called endogenous uncertainty (Kurz and Wu, 1996). Such kind of endogenous uncertainty can also be caused by a complex web of contractual obligations that transmit individual risks and defaults and amplify them into correlated and collective risks an defaults (Chichilnisky and Wu, 2006). The conditions for such endogenous uncertainty include the departure from complete markets (Cass, Chichilnisky and Wu, 1996).

Secondly, we continue exploring the implications of uncoordinated diverse beliefs for market volatility and speculative trading. A particular focus is to demonstrate that the equilibrium prices can fluctuate more than the rational expectation prices when there is endogenous uncertainty with diverse beliefs (Wu and Guo, 2003). Asset price volatility and trading volume are influenced by the extent of belief heterogeneity, resulting a price-volume pattern consistent with empirical observations (Wu and Guo, 2004). It is also shown that an increase in leverage ratio causes higher price volatility under some sufficient conditions, while such result may not hold when the shocks are anticipated (Guo,Wang and Wu, 2011), raising an interesting challenge for further research.

Thirdly, we continue studying asset pricing and corporate finance with diverse beliefs and higher order beliefs. On direction is to follow the insights of Keynes (1936) on beauty contest to allow the agents to have different orders of beliefs. It is demonstrated that price drift and empirically observed patterns of trading volume can be generated with diverse orders of beliefs, with the price pattern distinctly different from that of rational expectations framework. Moreover, the advantages of agents with higher order of beliefs are shown to depend on the primitives of their information precisions (Wu and Qiu, 2010). We also examine the pricing pattern when there is diverse beliefs and the corporate decision including initial public offerings with divergent opinions (Xu, 2007, Chen and Guo,2010), that are also distinct from past work based on rational expectations.

The future research of this group will continue with the three aspects of the new direction as mentioned above. In addition, we will search for a unified understanding of the 2008 financial crisis with our framework of endogenous uncertainty and uncoordinated diverse beliefs. Moreover, we will also study the impacts of the new set of financial regulations on market volatility and proper functioning of the global financial market.

Members

Wen-Chung Guo
Ho-Mou Wu
Jianguo Xu

Columbia node

Leader: Michael Woodford
The research group at Columbia University has broad interests in the role of subjective and heterogeneous expectations in coordination failures, delays in adjustment to changing conditions, and economic instability. Areas of application include both financial economics and macroeconomics, as well as the interaction between financial markets and the macroeconomy, and researchers in both the Department of Economics and the Graduate School of Business are expected to be involved. Researchers affiliated with the group at this time include Patrick Bolton, Bentley MacLeod, Bruce Preston, Ricardo Reis, Tano Santos and Michael Woodford.

Researchers at Columbia explore problems relating to expectational coordination using a variety of possible assumptions about expectation formation. Broadly speaking, departures from the assumption of full-information rational expectations can be grouped under two headings: approaches under which people may be assumed to correctly understand how to forecast future conditions conditional upon the economy’s current state, but have imperfect awareness of the current state; and approaches under which people are assumed to share a common (and correct) awareness of the current state, but do not correctly understand the implications of the current state for the probability of reaching various possible states in the future. Models of “sticky information” (Mankiw and Reis, 2002; Reis, 2006a, 2006b, 2009) or of “rational inattention” (Woodford, 2009) are important examples of the first type, which allow for incompleteness and heterogeneity of information beyond that which follows from differences in what is observable in principle because of the structure of the physical world. Models of least-squares learning (Preston, 2005, 2008; Eusepi and Preston, 2010, 2011), other models of adaptive learning (Woodford, 1990), characterizations of “near-rational expectations” (Woodford, 2010), and models in which signals are interpreted differently by different agents owing to heterogeneous priors (Bolton, Scheinkman and Xiong, 2006) are examples of approaches of the second kind. Columbia researchers have been important in the development of approaches of each of these types, and understanding the relations between conclusions reached using these different approaches, and determining the degree of practical relevance of the different approaches are important issues for the research agenda of the group.

A particular focus of the Columbia group is the investigation of empirical evidence for particular types of departures from full-information rational expectations, and the development of empirically relevant alternative specifications. By contrast with much early work, that considered alternative specifications of expectations as a way of strengthening the foundations of rational-expectations analysis — for example, analyzing the conditions under which rational-expectations equilibrium should be “learnable” (Preston, 2005), or using stability under learning dynamics as a criterion for equilibrium selection (Woodford, 1990) — the primary current interest of the group is in alternative specifications of expectation formation as explanations of observable phenomena that would not occur in a rational-expectations equilibria. Empirical evidence is sought through the study of survey data on expectations (Mankiw, Reis and Wolfers, 2004), through investigation of the extent to which “calibrated” numerical models can explain quantitative features of economic time series under alternative assumptions about expectations (Mankiw and Reis, 2002; Woodford, 2009; Eusepi and Preston, 2011), and through formal econometric estimation of models that incorporate particular models of expectation formation (Reis, 2009; and work in progress by Eusepi, Giannoni and Preston).

Another particular focus of the Columbia group is analysis of the consequences of alternative models of expectation formation for economic policy design, with applications both to the conduct of macroeconomic stabilization policies and to the regulation and supervision of the financial sector. One research aim is to consider how conclusions about the character of optimal policy — or about the comparative desirability of particular policy alternatives — change depending on the assumption that is made about expectation formation (e.g., Ball, Mankiw and Reis, 2005; Bolton, Scheinkman and Xiong, 2006; Preston, 2008; Reis, 2009; Eusepi and Preston, 2010; Woodford, 2011). Another is to consider how to choose policies that are relatively robust to alternative assumptions about expectations, rather than assuming that the policy analyst can be predict people’s expectations with certainty (e.g., Woodford, 2010; Adam and Woodford, 2010). In addition to reconsidering the choice among conventional policy reaction functions or regulatory proposals under alternative assumptions, particular concerns of the group include the role that central-bank or government announcements can play in helping to shape expectations and hence equilibrium outcomes in a desirable way (e.g., Woodford, 2005; Eusepi and Preston, 2010), and the use that should be made of evidence regarding private-sector expectations in the conduct of public policy (e.g., Bernanke and Woodford, 1997; Preston, 2008).

The problem of expectation formation is particularly acute when it comes to new regulation. Regulations by their nature create a new “game” or set of incentives to which individual actors respond. Often it is very difficult to anticipate all of the consequences of new regulation. A goal of this project will be to find ways to articulate and model the game of new regulations and incentive mechanisms. Both the current crises and the U.S. savings and loan crisis of the 1980s arose because regulators were not able to anticipate how actors would respond and innovate in the face of new rules. See MacLeod (1996, 2002) for some models of decision making in the face of an incomplete model of the world. See also MacLeod (2007) for a discussion of conditions under which reputation forces may constrain individual behavior. This work highlights the limits to relying upon market forces to ensure appropriate behavior.

A first collective activity of the Columbia University “node” is a conference on “Heterogeneous Expectations and Economic Stability,” to held at Columbia on February 11, 2011. The program of this conference is attached to this report.

Members

William Bentley MacLeod
Patrick Bolton
Bruce Preston
Ricardo Reis
Tano Santos
Michael Woodford

Israeli node

Leader: Elchanan Ben-Porath
The Israeli group consists of game theorists who are interested in applying solution concepts that have been developed in the game-theoretical literature to problems that involve the functioning of .nancial markets and competitive economies. Three more specific issues that members in the group have worked on are: (1) The information conveyed by prices when there is common knowledge of rationality but where agents may have heterogenous beliefs on the relationship between the prices and the states of nature. (2) Adaptive heuristics in dynamic economies. (3) Applications of the theory of global games to problems in .financial markets and Macroeconomics. The members that are currently affiliated with the group are: Elchanan Ben-Porath, Aviad Heifetz, and Ady Pauzner. Sergiu Hart plans to participate in the activities of the group but since he is now fully financed by an ERC grant prefers not to be listed as a member of the group. Following is a brief description of the research of members in the group that is relevant to the theme of the project.

Ben-Porath and Heifetz study exchange economies with incomplete information and characterize the set of outcomes that is consistent with common knowledge of rationality when different agents may have different beliefs about the relationship between the prices and the states of nature. In a second paper this result is applied to an economy where agents trade in contingent assets. The main result characterizes the set of prices that are consistent with common knowledge rationality in terms of the information partitions and initial endowments of the agents. Both papers highlight the dramatic difference between the predictions of Rational Expectations Equilibrium which typically has a unique solution and the multiplicity of the outcomes that are consistent with common knowledge of rationality.

In a series of papers Sergiu Hart has studied the implications of adaptive heuristics, notably regeret-matching, in repeated games (most of this work is joint with Andreu Mas-Colell). A heuristic is a rule of behavior that is simple – a .rule of thumb”. A heuristic is adaptive if it induces a behaviour that reacts to what happens in the environment in directions that loosely speaking seem better. Sergiu is interested in extending this approach to the analysis of dynamic economies.

Ady Pauzner.s research has focused on extending the theory of global games (which offers a theoretical tool that selects among multiple equilibria) and applying it to Financial markets and Macroeconomic models. In particular, Ady (in a joint work with Itay Goldstein) developed a model which selects among the two equilibria in the classical bank runs model of Diamond and Dybvig. The model relates the probability of a bank run to the parameters of the demand deposit contract that is offered by the bank to the depositors. Another paper (also, with Goldstein) uses the same theoretical tools to investigate the possibility that a financial crisis will cross country borders even when there are no economic dependencies between the countries – apart from the fact that the global investors diversify their investment portfolios between the countries.

Members

Elchanan Ben-Porath
Aviad Heifetz

NYU node

Leader: Jess Benhabib
Several faculty at NYU are interested in the broad subject of macroeconomic fluctuations and their relation to learning, expectation coordination, multiple equilibria, coordination failure, sunspots and rare events with large deviations. The interested faculty so far are Jess Benhabib, Alberto Bisin, Xavier Gabaix and Thomas Sadzik.

Jess Benhabib has worked on macroeconomic indeterminacies, multiple equilibria and sunspot equilibria in the context of business cycles, economic growth and monetary policy. He is currently interested in learning models along the lines of Evans and Honkapohja and implication for macroeconomic fluctuations in the context of rare events, large deviations and heterogeneous agents, and for problems of macroeconomic policy coordination.

Alberto Bisin’s interests in macroeconomics concern mostly the study of the role of financial market frictions as an amplification mechanism of business cycles and as a filter to monetary policy in the context of heterogeneous agents. They extend as well to the study of the role of financial market frictions in explaining wealth inequality and in affecting redistributive financial policies and on behavioral economics and on the transmission of culture has important implication in macroeconomics, e.g., on savings behavior and entrepreneurship.

Xavier Gabaix is a behavioral economist interested in macroeconomics and finance. He’s currently working on a tractable model of bounded rationality. “In A Sparsity-Based Model of Bounded Rationality”, he proposes a model with boundedly rational features in which the decision-maker (DM) builds a simplified representation of the world. Crucially, this representation is “sparse,” i.e., uses few parameters that are non-zero, or differ from the usual state of affairs. The DM may imperfectly maximize, based again on a penalty related to sparsity. Sparsity is formulated so as to lead to well-behaved, convex maximization problems. The model is a tractable algorithm that can be used with paper and pencil in many situations of interest. For instance, it offers a way to model boundedly rational dynamic programming. I apply it to a variety of prototypical economic situations: choosing an action while considering only subset aspects of the problem; selecting a consumption bundle with imperfect understanding of prices; optimal pricing with boundedly rational consumers — which generates a novel mechanism for price rigidity; life-cycle consumption and investment problems; portfolio choice with imperfect understanding of the structure of returns. Ongoing work extends the model to many agents, who form boundedly rational expectations about other agent’s actions.

Thomas Sadzig would like to investigate the relationship between the asset price bubbles and the coordination of expectations. In particular, recent literature (following up on Abreu and Brunnermaier 2003) focuses on the bubbles as arising out of miscoordination of beliefs about the fundamentals, while still maintain standard equilibrium assumption (full coordination of expectations about the actions). Drawing on the ideas from his recent paper on coordination in learning, he would like to relate bubbles more directly to miscoordinated expectations about agents’ actions, learning rules. For example, would small miscoordination of beliefs about agents’ actions lead to lasting bubbles? Can bubbles exist while agents coordinate their beliefs on small action sets, or sets of learning rules? Answering those, and other questions in the spirit of Eductive Stability (see Guesnerie 2005 for a review) would hopefully shed more light on the asset price bubbles.

The common interests of this group on expectation formation and macroeconomic fluctuations should fit in well with the project on expectational coordination (or lack thereof) in financial markets.

Members

Jess Benhabib
Alberto Bisin
Xavier Gabaix
Tomasz Sadzik

Oregon node

Leader: George W. Evans
Future research enlarges considerably the prospects of past research, which however serves as a building block. We will use both adaptive (Marcet-Sargent, JET, 1989 and Evans-Honkapohja (2001)) and eductive (Guesnerie, AER 2002) learning approaches to study expectation coordination in macroeconomics and finance. Economic questions of interest are business cycle fluctuations, asset price bubbles, financial crises, and macroeconomic policy in the face of major disruptions to expectational coordination.

(a) In current research (Evans, Guesnerie & McGough (2010)), we examine eductive coordination of expectations in the Real Business Cycle model with long-lived agents. We find that coordination cannot be expected, and this “impossibility” theorem for eductive learning has implications for expectational dynamics under adaptive learning.

(b) In shadow price learning, (Evans and McGough), we devise a model of bounded optimality for long-horizon agents, in which agents solve and update suitable two-period decision problems, using adaptive learning. This approach can be embedded in both macroeconomic and asset-pricing models.

© Planning horizons (Branch, McGough and Evans). The concept of the planning horizon is further developed in finite-horizon learning. This generalizes both one-step ahead Euler-equation learning and infinite-horizon learning (e.g. Preston JME 2006).

References.

Branch W andG Evans(2010), ‘Learning about Risk and Return: A Simple Model of Bubbles and Crashes,” forthcoming American Economic Journal: Macro, July 2011.

Branch W, Evans G andB. McGough(2010), ‘Finite Horizon Learning.’

Branch, W, Carlson J, Evans G, andB. McGough(2009), “Monetary Policy, Endogenous Inattention, and the Volatility Tradeoff,” Economic Journal, vol. 119, 123-157.

Branch W andB. McGough(2010) “Business Cycle Amplification with Heterogeneous Expectations,” forthcoming Economic Theory.

Evans G. (1985) “Expectational Stability and the Multiple Equilibria Problem in Linear Rational Expectations Models,” Quarterly Journal of Economics, Vol. 100, 1217-1234.

Evans G. andR. Guesnerie(1993) “Rationalizability, Strong Rationality and Expectational Stability,”Games and Economic Behavior, Vol. 5, 632-646.

Evans G, Guesnerie R and B. McGough(2010).

Evans G, Guse, E and S. Honkapohja (2008).

Evans G. and S. Honkapohja (1998) “Economic Dynamics with Learning: New Stability Results,” Review of Economic Studies, Vol. 65, 23-44.

Evans G. and S. Honkapohja (2001) Learning and Expectations in Macroeconomics.

Evans G. and G. Ramey (1992) “Expectation Calculation and Macroeconomic Dynamics”.

Members

William A. Branch
George Evans
Seppo Honkapohja
Bruce McGough
Kaushik Mitra

Princeton node

Leader: Stephen Morris
The members of component of the Project on “Expectational Coordination and Financial Markets” are Princeton University Economics members, Sylvain Chassang, Stephen Morris, Hyun Song Shin and Satoru Takahashi. Morris and Shin have a longstanding research agenda focused on incorporating a richer understanding of beliefs and expectations into applied economic models, building on the view economic analysis is badly biased by “simplifying” assumptions in this area (like the “rational expectations hypothesis”). In recent and ongoing work, they have examined the implications of these models for the recent financial crisis and financial regulatory reform. Shin has used these ideas in policy work – returning recently from being the President of South Korea’s chief advisor on international economic policy and the G-20 process (which Korea was chairing in 2010) and he is becoming co-director of Princeton University’s Center for Economic Policy Analysis. Chassang and Takahashi are leaders in the younger generation of foundational work on the role of expectational coordination in strategic settings, with important joint work and work with other co-authors in this area. Both have strong links with the Paris School of Economics, Chassang through his undergraduate work with its faculty and Takahashi through his collaboration with Olivier Tercieux.

Members

Sylvain Chassang
Stephen Morris
Hyun Song Shin
Satoru Takahashi
Juan Pablo Xandri

Stanford node

Leader: Mordecai Kurz
The “Stanford Node” is an intellectual rather than a geographical description of the group of scholars who are expected to participate. I start by listing those who are likely to take part in this node.

Mordecai Kurz- Stanford University

Maurizio Motolese – The Catholic University of Milan

Carsten K. Nielsen – The Catholic University of Milan

Monica Piazzesi – Stanford University

Martin Schneider – Stanford University

Volker Wieland – The University of Frankfurt

Past research of this group has covered many topics from different perspectives. The view of Kurz, Motolese, Nielsen and Wu is that expectational coordination is rare hence diversity of market beliefs is generic. As a result, this group has studied the market consequences and policy implications of economies where diversity of belief persists. Their work has demonstrated diversity of beliefs has deep impact on financial markets and on economic dynamics. A brief summary can state that: (i) belief diversity is the main cause of high financial market volatility, high volume of trade, market bubbles and crashes, (ii) belief diversity is the main cause for an equity premium, (iii) belief diversity alters the nature of risk in financial markets thereby, in contrastto the standard way of defining risk in terms of realizations of exogenous shocks, the crucial risk any agent faces in the economy is the risk of what the market will believe in the future. Future market belief is a keydeterminant of future asset prices, future inflation rates or recessions. (iv) Although stabilization policy is desired by most in society, in economies with diverse beliefs stabilization is typically not Pareto Optimal.

Hence, there is a need for new and alternative criteria for justifying stabilization policy and the role of a central bank. This is an important open problem. A few references are provided below.

This space is too narrow to permit an outline of future work planned by members of the group. A general statement one can make is that the group remains focused on exploring the following issues:

(i) Causes of aggregate fluctuations and asset price volatility, and the impact of non-coordinated

expectations on the amplification of economic volatility.

(ii) The link between real economic fluctuations and financial volatility.

(iii)The potential role of expectation coordination in economic stabilization.

(iv)Feasible stabilization policies and criteria for optimal stabilization policies.

(v) Empirical work on the impact of expectation coordination and diverse beliefs. There is a great need for reliable data sources that permit empirical studies of the issues. It is important that the International Network promotes the development of new data sources on market expectations.

Members

Carsten Krabbe Nielsen
Mordecai Kurz
Maurizio Motolese
Monika Piazzesi
Martin Schneider
Volker Wieland

Tokyo node

Leader: Daisuke Oyama
The Tokyo node is in fact a Japanese node. Its members are affiliated with the universities of Tokyo, (D. Oyama, A. Matsui), Hitotsubashi (T. Kunimoto), Hokkaido (N. Kudoh), or the Institute for policy studies (Y. Yasuda) and the University of Kyoto (K. Wakai). Some of them have preoccupations close to macroeconomics (N. Kudoh) or a IO background (Y. Yasuda); but most have a strong game-theoretical background with an emphasis on coordination. There are intellectual connections with some other parts of the network (the rationalizable foresight dynamics of Matsui-Oyama echo the eductive view of RBC model of Evans and al), as well as existing cooperation, with Princeton, Paris.

Members

Noritaka Kudoh
Takashi Kunimoto
Akihiko Matsui
Daisuke Oyama
Katsutoshi Wakai
Yosuke Yasuda

Zurich node

Leader: Thorsten Hens
The researchers in the Zürich node of the network (Marc Chesney,Thorsten Hens, Felix Kübler,Jean-Charles Rochet, Karl Schmedders) are from three different areas: General equilibrium (Hens, Kübler and Schmedders), Mathematical Finance (Chesney) and Contract Theory (Rochet).

Past research of this group has covered many topics from different perspectives. Hens has gained some experience on expectational coordination while he studied the relation between sunpot equilibria and the multiplicity of equilibria. When he started this research it was well known that a coordination of expectations is needed when the underlying economy has multiple equilibria. However, Hens (2000), Hens and Pilgrim (2004) and Hens, Mayer and Pilgrim (2004) showed that even when the initial underlying economy has a unique equilibrium then trade in incomplete asset markets might lead to an ex post wealth distribution that allows for multiple equilibria so that the coordination problem among multiple equilibria was generated endogenously by asset trade. In his papers he also shows that the conditions on the underlying economy that allow for this surprising phenomenon are closely related to those needed for the transfer paradox known from international trade literature.

Kubler and Schmedders are the leading experts in computational economics and finance. Concerning the problem of expectational coordination, as early as 1999, Schmedders had already studied conditions for multiple equilibria with Hens and Voss in Hens, Schmedders and Voss (1999). That paper shows that assuming Cobb-Douglas utilities is not sufficient to rule out multiple equilibria when markets are incomplete. More recently Kubler and Schmedders (2011a) and Kubler and Schmedders (2011b) have developed new methods to track multiple equilibria, also for steady state equilibria in dynamic models.

Chesney is a leading expert in mathematical finance who recently studied the impact of exogenous events like terrorism on financial markets (Chesney, Reshetar and Karaman (2011)). Also, he is the leading expert in environmental finance. Rochet is one of the world best researchers in contract theory as applied to banking. His studies of the incentives in the financial crisis will help us to find a micro-foundation of the general equilibrium view.

In this research project our group will join forces to focus on the following research question:

Soros` Principle of Reflexivity and Speculative Bubbles in Production Economies

With hindsight, the history of speculative bubbles in financial markets seems to be good evidence that from time to time financial markets lead to a huge misallocation of resources. One is wondering for example how people in the Netherlands in 1636 were ready to pay more than the value of a house for a single rare tulip onion or why, more recently, Spain has doubled its hotel capacity from 2000 to 2008. On the other hand some of those speculative bubbles achieved the break through of important innovations like the rail road, the mass production, globalization, and information technologies. See Schleifer (2000, Chapter 6) for an overview of speculative bubbles from 1630 to 1999.

The aim of this subproject is to develop models that help sorting out the pros and cons of speculative bubbles so that policy makers get some help in acting on them. Unfortunately, speculative bubbles are an under-researched area of financial economics: Tirole`s (1985) analysis of rational bubbles in discrete time over lapping generations models is a useful benchmark case for us which however does not simultaneously explain the build up and the crash of a bubble. More recently, Abreu and Brunnermeier (2003) show that with continuous time exiting a bubble imposes too high synchronisation risk on the side of rational investors so that bubbles can last longer than one would think from a purely rational perspective. This is an important aspect of expectational coordination but it seems to hinge on the continuous time framework. On the other hand, speculative bubbles are known to arise in models with quite some ad-hoc assumptions, e.g. in the model of Brock and Hommes (1998) or Lux (1995). We think that these are seminal contributions but there is still a huge gap to be filled between these extremal points.

Despite the work of Brock and Hommes (1998), Lux (1995), Shleifer (2000) and Shiller (2000), the leading paradigm of financial economics has still worked with the rational expectations hypothesis, according to which economic fluctuations are not created from within the economic system but appear as exogenous surprises – just like the “black swans” described in the celebrated book by Taleb (2007). This deficiency of the leading paradigm of economics is often used by policy makers for excusing themselves not having acted on a speculative bubble. E.g. Alan Greenspan was always very sceptical to act against asset market bubbles. He said “How do we know when irrational exuberance has unduly escalated asset values?”. We hope that our project creates such knowledge.

The purpose of this subproject is to develop models of speculative bubbles balancing the pros and cons of speculation. At the core of the problem we see the interaction between speculation, investment and innovation. During a speculative bubble some firms get cheap credit which they can invest in new technologies creating new innovations. These innovations have positive externalities for other firms. Thus the question we need to analyze is how to trade off the inefficiencies due to cheap credit and the positive externalities from innovations.

Since we ultimately intend to do a normative analysis giving advice to policy makers it is mandatory to use a general equilibrium perspective. Many aspects of speculation already arise in exchange economies, but as we see it, the core of the problem can only be analysed in production economies. Because in those economies Soro`s principle of reflexivity is most severe:

“Financial markets attempt to predict a future that is contingent on the decisions people make in the present. Instead of just passively reflecting reality, financial markets are actively creating the reality that they, in turn, reflect. There is a two way connection between present decisions and the future events, which I call reflexivity.” (Soros (1998), page xxiii)

To be successful with our research project we divide it into the following milestones

We need to develop a general equilibrium, model with production and

  1. credit constraints.
  2. credit constraints and speculation.
  3. credit constraints, speculation and externalities.
    In a sense we intend to build a general equilibrium version of the famous Kiyotaki and Moore (1997) model of credit cycles. For the first milestone we can build on the general equilibrium literature modelling collateral, e.g. Dubey, Geanakoplos, and Shubik (2005) and Geanakoplos, Zame (2010). These models need however be extended to production economies. We are aware of the problems incorporating production in a general equilibrium model when markets are incomplete, as pointed out by Dreze (1974) and many others thereafter (see Magill and Quinzii (1996), Chapter 6 for a systematic account). In order not to overload, in a first attempt the model we are willing to assume that markets are complete. For the second milestone we need to blend in second order beliefs that give rise to speculative bubbles, as suggested by Keynes (1936) a long time ago and used recently in e.g. Bacchetta and Van Wincoop (2004) who build on the framework of Morris and Shin (2002). Finally, we want to extend the model towards production externalities, e.g. in the sense of Allen (1982).

Members

Marc Chesney
Thorsten Hens
Felix Kübler
Jean-Charles Rochet
Karl Schmedders

Members

The members, previous work and new directions.

Klaus Adam
Member of the Barcelona University node
Mikhail Anufriev
Member of the Amsterdam University node
Tiziana Assenza
Member of the Amsterdam University node
Te Bao
Member of the Amsterdam University node
Elchanan Ben-Porath
Member of the Israeli node
Jess Benhabib
Member of the New York University node
William Bentley MacLeod
Member of the Columbia University node
Milo Bianchi
Member of the Fellows
Alberto Bisin
Member of the New York University node
Patrick Bolton
Member of the Columbia University node
William A. Branch
Member of the Oregon University node
William Brock
Member of the Fellows
Gabriel Desgranges
Member of the Paris node
Hector Calvo Prado
Member of the Fellows
Sylvain Chassang
Member of the Princeton University node
Marc Chesney
Member of the Zurich University node
Cees Diks
Member of the Amsterdam University node
Juan Escobar
Member of the Chile University node
George Evans
Member of the Oregon University node
Xavier Gabaix
Member of the New York University node
Gaetano Gaballo
Member of the Paris node
Stephane Gauthier
Member of the Paris node
Pierre Yves Geoffard
Member of the Paris node
Sayantan Ghosal
Member of the Fellows
Roger Guesnerie
Member of the Paris node
Wen-Chung Guo
Member of the China node
Rodrigo Harrison
Member of the Chile University node
Aviad Heifetz
Member of the Israeli node
Frank Heinemann
Member of the Fellows
Thorsten Hens
Member of the Zurich University node
Cars H. Hommes
Member of the Amsterdam University node
Seppo Honkapohja
Member of the Oregon University node
Pedro Jara
Member of the Chile University node
Alejandro Jofre
Member of the Chile University node
Carsten Krabbe Nielsen
Member of the Stanford University node
Noritaka Kudoh
Member of the Tokyo University node
Takashi Kunimoto
Member of the Tokyo University node
Felix Kübler
Member of the Zurich University node
Mordecai Kurz
Member of the Stanford University node
Albert Marcet
Member of the Barcelona University node
Stephen LeRoy
Member of the Fellows
Wilfredo Maldonado
Member of the Fellows
Ramon Marimon
Member of the Barcelona University node
Akihiko Matsui
Member of the Tokyo University node
Bruce McGough
Member of the Oregon University node
Kaushik Mitra
Member of the Oregon University node
Stephen Morris
Member of the Princeton University node
Maurizio Motolese
Member of the Stanford University node
Daisuke Oyama
Member of the Tokyo University node
Aloisio Pessoa de Araujo
Member of the Fellows
Remco Peters
Member of the Fellows
Monika Piazzesi
Member of the Stanford University node
Guillaume Plantin
Member of the Fellows
Bruce Preston
Member of the Columbia University node
Ricardo Reis
Member of the Columbia University node
Jean-Charles Rochet
Member of the Zurich University node
Terry Rockafellar
Member of the Chile University node
Tomasz Sadzik
Member of the New York University node
Tano Santos
Member of the Columbia University node
Karl Schmedders
Member of the Zurich University node
Martin Schneider
Member of the Stanford University node
Giulio Seccia
Member of the Fellows
Hyun Song Shin
Member of the Princeton University node
Satoru Takahashi
Member of the Princeton University node
Olivier Tercieux
Member of the Paris node
Jan Tuinstra
Member of the Amsterdam University node
Robin de Vilder
Member of the Fellows
Florian Wagener
Member of the Amsterdam University node
Katsutoshi Wakai
Member of the Tokyo University node
Roger Wets
Member of the Chile University node
Jörgen Weibull
Member of the Fellows
Volker Wieland
Member of the Stanford University node
Michael Woodford
Member of the Columbia University node
Ho-Mou Wu
Member of the China node
Juan Pablo Xandri
Member of the Princeton University node
Jianguo Xu
Member of the China node
Yosuke Yasuda
Member of the Tokyo University node

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INEXC Job Offers
Post doctoral Researcher- 2015 INEXC is inviting applications for two postdoctoral fellowships starting in Fall 2015. Offer #1. INEXC is offering a 3-months post- doctoral […]

Published in Latest updates on August 10, 2015

Expectations in Dynamic Macroeconomic Models – Call for Papers
Call for Papers Friends and colleagues, We invite paper submissions for the conference on “Expectations in Dynamic Macroeconomic Models,” to be held in Eugene, Oregon, […]

Published in Latest updates on March 6, 2015

Learning in Macroeconomics and Finance, 19-20 June, Barcelona
Program Balmes Building (UPF) – Balmes 132, Barcelona Download the program here June 19 09:00-11:00. Session 1 Chair: Roger Guesnerie – TE BAO (University of Groningen) […]

Published in Latest updates on January 20, 2014

Fourth INEXC Conference, 22-23 February 2014, New York
Program Conference Location: 5 Washington Place (corner of Mercer St. and Washington Place) Room 101 (First Floor Auditorium) Saturday, February 22: Inattention and Economic Choice […]

Published in Applications, Latest updates on November 25, 2013

Third INEXC Conference, 24-25 June 2013, Paris
Program Salle 5- Collège de France, 11 Place Marcelin Berthelot, 75005, Paris Monday June 24th Morning: 10.15am- 12.15pm - 10.15am-11.15am: Steve Morris (Princeton), “Rational Expectations Equilibria […]

Published in Applications, Latest updates on April 21, 2013

Cars Hommes – New Book
“Behavioral Rationality and Heterogeneous Expectations in Complex Economic Systems ” by Cars Hommes, published by Cambridge University Press. The pdf file of the introductory chapters can […]

Published in Amsterdam University node, Latest updates on April 21, 2013

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