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faculty: "FEB" and publication year: "2006"
| Authors||W.A. Brock, P.D.E. Dindo, C.H. Hommes|
|Title||Adaptive rational equilibrium with forward looking agents|
|Journal||International Journal of Economic Theory|
|Faculty||Faculty of Economics and Business|
|Institute/dept.||FEB: Amsterdam School of Economics Research Institute (ASE-RI)|
|Abstract||In adaptive rational equilibrium dynamics (ARED) agents choose between a costly|
rational expectation forecast and a cheap naive forecast, and the fractions using
each of the two strategies evolve over time and are endogenously coupled to the
market equilibrium price dynamics. In this setting, agents are backward looking in
the sense that strategy selection is based on experience measured by relative past
realized profits.When the selection pressure to switch to the more profitable strategy
is high, instability and complicated chaotic price fluctuations arise.
In this paper we investigate the ARED with forward looking agents, whose strategy
selection is based upon expected profits. Our findings suggest that forward looking
behavior dampens the amplitude of price fluctuations, but local instability of the
steady state remains. The global dynamics depends upon how sophisticated the forward
looking behavior is.With perfectly forward looking agents, prices converge to a
stable 2-cycle, whereas with forward looking agents who are boundedly rational concerning
their estimate of expected profits, small amplitude chaotic price fluctuations
We also establish an equivalence relationship between a heterogeneous agent model
with switching of strategies and a representative agent framework, where the representative
agent optimally chooses between the benefits of a high quality forecast and
the associated information gathering costs. To an outside observer it is impossible to
distinguish between the two.
Key words heterogeneous beliefs, discrete choice dynamics, cobweb model, endogenous
business cycles, chaos
JEL classification C60, D83, D84, E32
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