Expectation Formation and Endogenous Fluctuations in Aggregate Demand

Expectation Formation and Endogenous
Fluctuations in Aggregate Demand

Maciej K. Dudek*

December 24, 2003

Abstract

The paper recognizes that expectations and the process of their for-
mation are subject to standard decision making and are determined as a
part of equilibrium. Accordingly, the paper presents a basic framework in
which the form of expectation formation is a choice variable. At any point
in time rational economic agents decide on the basis of the level of utility
what expectation formation technology to use and as a consequence what
expectations to hold. As economic decisions are conditioned on expecta-
tions holding proper or rational expectations eliminates the possibility of
ex ante inefficiencies. The choice of expectation formation technology is
not trivial as the paper assumes that information gathering and processing
are costly. Consequently, economic agents must make informed decisions
with the regard to the quality of expectation formation technologies they
wish to use. The paper shows that agents’ optimization over expectations
not only adds on to realism, but also can carry non trivial implications
for the behavior of macroeconomic variables. Specifically, the paper illus-
trates that endogenous expectation revisions can be a source of perma-
nent oscillations in aggregate demand and can prevent an economy from
settling into a steady state. In addition, the paper quantifies intangible
notions such as overheating, overborrowing, and output gap. Finally, the
paper shows that active policy measures can limit inefficiencies resulting
from output fluctuations.

JEL Classification Numbers: D84, E32.

Key Words: Business Cycles, Expectation Formation, Costly Informa-
tion Acquisition.

1 Introduction

Short run oscillatory movements in macroeconomic variables are a distinctive
characteristic of modern economies. Accordingly, the phenomenon has been cen-
tral to macroeconomic analysis. The paper contributes to the extensive existing
literature and presents a complementary rationalization for the occurrence of

* Please send comments to [email protected].

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