Expectation Formation and Endogenous Fluctuations in Aggregate Demand

recession and expansions. The paper offers a novel approach. It builds on a
recent contribution of Brock and Hommes [7] and argues that expectations can
be a key determinant of short run macroeconomic performance. Specifically, it
shows, in a general equilibrium framework, that rational selection of different
expectation formation technologies can be a source of endogenous fluctuations
in aggregate demand.

The stark coexistence of recessions and expansions has attracted a consid-
erable attention from the profession. Historically economists have attempted
to account for business cycles by interpreting them as combinations of deter-
ministic cycles of different lengths. However, efforts to represent fluctuations in
aggregate output as the outcome of regular Kitchin (3-year), Juglar (10-year),
Kuznets (20-year), and Kondratiev (50-year) cycles have been abandoned in
favor of approaches that emphasize either the importance of stochastic distur-
bances, or the interaction of expectations and multiple equilibria, or assign the
key responsibility to intrinsic nonlinearities of macroeconomic systems.

The real business cycle literature based on stochastic dynamic equilibrium
models and spurred by the initial contribution of Kydland and Prescott [39]
defines the main stream approach towards understanding short run fluctuation.
The approach relies on general equilibrium modelling and identifies exogenous
technology, taste or government purchases shocks as the driving forces of busi-
ness cycles. The approach has proven to be relatively successful in accounting
for qualitative and quantitative aspects of business cycles. This paper shares
with the main stream general equilibrium approach. However, the results its
presents add on to the existing literature. Specifically, the paper shows that
cycles need not imply, even in the absence of nominal rigidities, movements in
the potential level of output.

The second approach, most notable examples being Diamond [15], Kiyotaki
[29], exploits the fact that a priori economic systems need not have unique
equilibria and, therefore, downturns and upswings in economic activity can be
an outcome of movements between different equilibria. The approach despite
its theoretical appeal requires several tacit assumptions with the need for the
existence of exogenous coordinating device being a key shortcoming. Moreover,
voluntary coordination by rational and high payoff seeking economic agents on
an inferior equilibrium implies that fluctuations and resulting welfare losses are
largely self-inflicted and most importantly totally avoidable.

The contributions in the third group, Grandmont [22], Aghion, Banerjee
and Piketty [2], Matsuyama [32], [33] note that the cyclicality in macroeco-
nomic variables can be an inherent property of macroeconomic systems and
fluctuations can in fact be endogenous. This paper falls into this final category,
i.e., it argues that high frequency dynamics in macroeconomic variables can be
endogenous. However, unlike other contributions it illustrates that equilibrium
actions of rational and high payoff seeking economic agents rather than intrin-
sic properties of the underlying equilibrium equations can induce fluctuations
in systems that are otherwise stable.

The paper develops a general equilibrium model based on the OLG model of
Diamond [14] and the monopolistic competition model of Blanchard and Kiy-

<<   1   2   3   4   5   >>

More intriguing information