Rational Diverse Beliefs and Economic Volatility

This paper explores works which contribute to explaining market dynamics and volatility by employing models of rational but diverse beliefs. The first part gives a complete exposition of Noisy Rational Expectations (i.e. REE) Asset Pricing Theory where diversity of beliefs arises from diverse private information. The general conclusion is that, although Noisy REE asset pricing theories have many attractive features, they do not offer a satisfactory paradigm for market dynamics. Indeed, for most models increased amount of idiosyncratic private information leads to a reduction in volatility. We next turn to models of diverse beliefs without private information. We explore work on Rational Belief Equilibria (i.e. RBE) starting with modeling beliefs. It is shown that to be rational a belief cannot be constant, creating an endogenous mechanism for market dynamics. For the development of an equilibrium theory, beliefs are treated as a vector of state variables and market belief is the distribution of individual beliefs. Market belief is an observable for which ample data is available and we review both data sources and applications which use such data. Much of the material reviewed covers the applications of this theory to the study of market dynamics.