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The Rationality of Expectations Formation

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  • Dávila Julio

    (Center for Operations Research and Econometrics, Université c. de Louvain, Louvain-la-Neuve, Belgium)

Abstract

Rational expectations are not required to follow from beliefs that explain well history, but just to correctly foresee the future. As a consequence, at a rational expectations equilibrium, the agents’ expectations may follow from beliefs that explain poorly the observed history, even among those rationalizing their choices. This paper shows, firstly, that if agents hold rationally formed expectations instead – in the sense of following from beliefs that explain history better than any other beliefs justifying their choices – then allocations unsupported by rational expectations can be shown to be equilibrium outcomes. By means of this result, it is established, secondly, that adding the common knowledge of the rationality of the formation of expectations to that of the rationality of choices and of market clearing, still does not suffice to guarantee rational expectations. Finally, the rationally formed expectations equilibria produced in this paper exhibit a sunspot-like volatility that, interestingly enough, do not rely on an explicit sunspot mechanism.

Suggested Citation

  • Dávila Julio, 2016. "The Rationality of Expectations Formation," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 16(2), pages 515-543, June.
    • Handle: RePEc:bpj:bejtec:v:16:y:2016:i:2:p:515-543:n:1
    DOI: 10.1515/bejte-2014-0082
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    References listed on IDEAS

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    1. Hindriks, Jean & Myles, Gareth D., 2013. "Intermediate Public Economics," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262018691, April.
    2. Fujita,Masahisa & Thisse,Jacques-François, 2013. "Economics of Agglomeration," Cambridge Books, Cambridge University Press, number 9780521171960, October.
    3. Radner, Roy, 1979. "Rational Expectations Equilibrium: Generic Existence and the Information Revealed by Prices," Econometrica, Econometric Society, vol. 47(3), pages 655-678, May.
    4. Lucas, Robert E, Jr, 1986. "Adaptive Behavior and Economic Theory," The Journal of Business, University of Chicago Press, vol. 59(4), pages 401-426, October.
    5. Barnett,William A. & Geweke,John & Shell,Karl (ed.), 1989. "Economic Complexity: Chaos, Sunspots, Bubbles, and Nonlinearity," Cambridge Books, Cambridge University Press, number 9780521355636, October.
    6. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
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    Cited by:

    1. Chatterji, Shurojit & Kajii, Atsushi, 2023. "Decentralizability of efficient allocations with heterogeneous forecasts," Journal of Economic Theory, Elsevier, vol. 207(C).

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    More about this item

    Keywords

    rationality; expectations; overlapping generations;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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