Expectation Formation and Endogenous Fluctuations in Aggregate Demand



policy leading to smoothing of deviations of output from long run trend can
limit welfare losses.

6 Conclusions

The paper recognizes that expectations and the process of expectation forma-
tion are not, in principle, imposed on the economy, but rather that they are
subject to the discretion of economic agents and are determined as a part of
equilibrium. Consequently, the paper develops a framework in which agents at
any point in time decide in an individually rational manner what expectations
to hold. Expectations are derived from speci
fic expectation formation technolo-
gies and are chosen on the basis of the level of utility they are expected to yield.
The set of feasible expectation formation technologies comprises both a perfect
foresight technology and "naive," based on past experience, expectation forma-
tion technologies. The perfect foresight technology allows for optimal savings
decision whereas the "naive" expectation formation technologies need not suf-
fice to guarantee efficiency along the intertemporal margin. The choice of an
expectation formation technology is not trivial as the paper assumes that expec-
tation formation is costly. Speci
fically, the more accurate a given expectation
formation technology is the higher its costs. Therefore, economic agents willing
to attain e
fficiency along the intertemporal margin must pay a high expectation
formation cost on the other hand those who choose to rely on past experience
face the risk of suboptimal saving behavior, but save on information gathering
and processing costs. Agents weigh the two costs and make informed decisions
with the regard to the type of expectations they wish to hold.

While the assumption of Agents’ discretion over expectations adds on to real-
ism it also carries non trivial implications. The paper develops a model in which
the economy follows an unstable dynamic equation when all agents choose to
form expectations in an adaptive manner and follows a dynamic equation that
settles into a rest point if economic agents choose to form expectations in a
perfect foresight manner. This basic structure, as noted by Brock and Hommes
[7], leads in a natural manner to endogenous
fluctuations in macroeconomic
variables. Speci
fically, the paper establishes that rational choice over expecta-
tions can lead to endogenous
fluctuations in aggregate demand. Optimization
over expectations makes agents alternate between better and worse expectation
formation technologies depending on the distance from a potential rest point.
The closer the economy is to a potential rest point the more current outcomes
resemble future outcomes. Therefore, expectations based on naive expectation
formation technologies allow for nearly optimal behavior along the intertempo-
ral margin and at the same time do not involve any information gathering and
processing costs. Naturally, rational agents on the approach path, where the
economy is su
fficiently stable, to a potential rest point choose to rely on coarser
expectation formation technologies and eventually turn towards naive expecta-
tions. However, if all agents choose to form expectations in an adaptive manner
the economy enters an unstable path and errors of perception become larger and

31



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