Expectation Formation and Endogenous Fluctuations in Aggregate Demand

otaki [5]. The presence of monopolistic competition allows the composition of
aggregate demand aside from fundamentals: preferences, technology, and re-
sources affect aggregate output. The composition of aggregate demand depends
amongst other factors on the perception of the future. In particular, an expecta-
tion of high income flows in the future results, due to intertemporal smoothing,
in low savings today. Low savings imply high consumption, which leads to high
output. Conversely, an expectation of low income streams in the future provides
an incentive to increase savings. Increased savings curtail consumption and re-
sult in low output. Consequently, changes in expectations lead to fluctuations
in aggregate output. Expectations, however, are not assumed to be exogenous.
Quite the contrary expectations and foremost the process of their formation are
endogenized and any changes in expectations constitute an equilibrium outcome.

The paper follows the methodology of Brock and Hommes [7] and endoge-
nizes expectation formation in an environment in which it is costly to collect
and process information. Specifically, the paper assumes that economic agents
need to expend resources if they wish to obtain reliable assessments of the fu-
ture values of macroeconomic variables. In particular, naive assessments, based
on past realizations and past experience, are assumed to be costless. On the
other hand perfect foresight assessment can be obtained only at a cost. Natu-
rally, expectations based on naive assessments allow economic agents to save on
the information gathering and processing costs, but lead to mistakes along the
intertemporal margin and result in a loss in terms of utility as the consump-
tion profile is not smoothened out optimally. Similarly, expectations formed
on the basis of reliable assessments eliminate the possibility of errors along the
intertemporal margin and do not impose direct losses in terms of utility, but
can be formed provided that the proper information gathering and processing
costs have been accrued. Naturally, rational agents need to balance the two
effects in equilibrium and make an informed decision with regard to the type of
expectations they wish to hold.

The paper shows that the desire of economic agents to economize on infor-
mation gathering and processing costs can prevent an economy from settling
into a steady state. The paper develops a model in which the economy follows
and unstable dynamic equation when all economic agents choose to form expec-
tations in an adaptive manner and follows a dynamic equation that settles into
a rest point if economic agents choose to form expectations in a rational (perfect
foresight) manner. Therefore, adaptive or naive learning, expectations based on
past experience, puts the economy on explosive trajectories and ultimately must
result in significant errors along the intertemporal margin and a substantial loss
in terms of utility. Economic agents in the face of significant errors along the
intertemporal margin expend resources and shift toward rational assessments of
the future. This puts the economy on a convergent path. However, the econ-
omy never converges towards a steady state. Convergence implies by definition
that future outcomes resemble current outcomes, therefore, were convergence
to occur passive or adaptive learning would lead to minuscule errors along the
intertemporal margin. Consequently economic agents would find it optimal to
switch toward adaptive learning. This, however, would lead to divergence and

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