Confounding Dynamics

In the context of a dynamic model with incomplete information, we isolate a novel mechanism of shock propagation that results in waves of optimism and pessimism along a Rational Expectations equilibrium. We term the mechanism confounding dynamics because it arises from agents’ optimal signal extraction efforts on variables whose dynamics—as opposed to superimposed noise—prevents full revelation of information. Employing methods in the space of analytic functions, we are able to obtain analytical characterizations of the equilibria that generalize the celebrated Hansen-Sargent optimal prediction formula. We apply our results to a canonical real business cycle model and derive the analytic solution for output, consumption and capital. We show that, in response to a permanent positive productivity shock, confounding dynamics generate expansions and recessions that would not be present under complete information.