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Business cycle amplification with heterogeneous expectations

William A. Branch and Bruce McGough
Economic Theory
Vol. 47, No. 2/3, Symposium on the Role of Market Belief in Economic Dynamics (June 2011), pp. 395-421
Published by: Springer
Stable URL: http://www.jstor.org/stable/41485844
Page Count: 27
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Business cycle amplification with heterogeneous expectations
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Abstract

This paper studies the implications for business cycle dynamics of heterogeneous expectations in a stochastic growth model. The assumption of homogeneous, rational expectations is replaced with a heterogeneous expectations model where a fraction of agents hold rational expectations and the remaining fraction adopt parsimonious forecasting models that are, in equilibrium, optimal within a restricted class. Our approach nests the literature on rational expectations in business cycle models with a recent approach based on adaptive learning. We demonstrate that (i.) heterogeneous expectations can lead to substantial improvement in the internal propagation of equilibrium business cycle models and (ii.) the internal propagation depends on the degree of heterogeneity. A calibrated model with heterogeneity provides a closer fit to business cycle data than its representative agent, rational expectations counterpart.

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