Expectation Formation and Endogenous Fluctuations in Aggregate Demand

that learning from past experience allows to fully identify the structure of the
economy. However, the paper illustrates that the structure of the economy is
itself affected by the learning process and hence any inferences based on past
data if used in decision making process affect the structure of the economy.
In other words, the paper presents an example of the Lucas Critique [31] in
the context learning and expectation formation affecting the structure of the
economy. Furthermore, it is shown that learning may under some parameter
values cause instability in systems that otherwise would tend to a steady state
equilibrium a point initially brought by Evans [16], Marcet and Sargent [34] in
a partial equilibrium context.

The recent contribution of Reis [41] shares many of the findings of this paper.
Specifically, the paper, as in Reis [41], shows that informational costs imply
that consumption profiles depart from the optimal first best. However, Reis’s
analysis in a partial equilibrium one and focuses on consumer behavior in the
context exogenously changing environment and costly information acquisition.
This paper is cast in a general equilibrium framework and shows that updates
of consumption plans can lead to endogenous changes in the environment and
to endogenous oscillations.

The paper is organized in six sections. Section (2) outlines the underlying
model. Section (3) determines the equilibrium. Section (4) endogenizes the
process of expectation formation and presents sample dynamics. Section (5)
focuses on policy considerations. Finally, section (6) concludes.

2 Model

There are three main components of the model. The intertemporal aspects
are captured in the framework of the Diamond [14] OLG model. In addition,
Blanchard and Kiyotaki [5] imperfect competition framework allows shifts in
the composition of aggregate demand to influence contemporaneous variables.
Finally, Brock and Hommes [7] approach is used to endogenize expectation
formation. The model is fully analytically tractable.

2.1 Agents

There are a continuum of measure one of agents born each period. Each agent
lives for two periods and is endowed with a unit of labor in the first period of
her life. An agent born at time t values consumption in the first period of her
life, when she is young, and consumption in the second period of her lifer, when
she is old. The preferences of an agent born at time t are represented by the
following utility function

U (cι,t,C2_ιt+ι) = log(c∙ι,_t) + log(c2_ιt + ι).                       (1)

The logarithmic utility simplifies the intertemporal problem immensely and is
chosen for analytic convenience.

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