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.

- Coordination of Expectations in Long-horizon Models. We focus on the likelihood of coordination on rational expectations (RE) equilibrium, the possibility of expectations-driven fluctuations, and the impact of the planning horizon for expectational dynamics.

(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.

(c) 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).

- Bubbles and Asset Price Volatility (Branch and Evans). We show, in a model with short-horizon agents and mean-variance preferences, that least-squares learning of the conditional variance and the expected return can lead to extended periods of excess volatility, bubbles and crashes.  Planned extensions include allowing for ARCH effects in the agents’ risk estimates and long-horizon versions.

- Financial Collapse and Expectations. (Branch, Evans, McGough and John Carlson (Cleveland FRB)). The financial crisis of 2008-9 underscored the possibility of a collapse of financial intermediation. Preliminary findings of our research indicate that after a large negative expectations shock, the path of the economy can evolve toward financial collapse. Suitable government policies could avoid this outcome.

- Deflation Traps and Macroeconomic Policy (Evans, Seppo Honkapohja (Bank ofFinland) andJess Benhabib (NYU)). Using the tools from adaptive learning theory we show the possibility of self-reinforcing feedback leading to a path with falling output, deflation and high real interest rates. Asymmetric price-adjustment costs can also generate a stagnation regime, with steady deflation and persistently low output.

- Further Topics. Other work in progress includes (i) Endogenous inattention and learning, (ii) Heterogeneity of expectations, (iii) Anticipated policy in long-horizon models, as in Evans-Honkapohja-Mitra JME, 2010, and (iv) Stability of sunspot equilibria.

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”.