Does Inflation Walk on Unstable Paths? Rational Sunspots and Drifting Parameters

Paolo Bonomolo and Guido Ascari

No 743, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: We propose a generalization of the rational expectations (RE) hypothesis: as in the original approach by Muth (1961), the case of multiple solutions is the natural case, and expectations are formed by randomizing across the infinite RE solutions. We call our approach: "rational sunspots". The infinite solutions differ in the way agents form their expectations, or more precisely in the way agents weight past data to make forecasts. It follows that our approach naturally yields drifting parameters and stochastic volatility. It also allows for the possibility of temporary explosive paths. Moreover, a simple method to distinguish between determinacy and indeterminacy is based on the Normality of the likelihood.

Date: 2012
New Economics Papers: this item is included in nep-for and nep-mon
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