Macroeconomics with Learning and Misspecification: A General Theory and Applications

Pooya Molavi

No 1584, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: This paper explores a form of bounded rationality where agents learn about the economy with possibly misspecified models. I consider a recursive general-equilibrium framework that nests a large class of macroeconomic models. Misspecification is represented as a constraint on the set of beliefs agents can entertain. I introduce the solution concept of constrained-rational expectations equilibrium (CREE), in which each agent selects the belief from her constrained set that is closest to the endogenous distribution of observables in the Kullback–Leibler divergence. If the set of permissible beliefs contains the rational-expectations equilibria (REE), then the REE are CREE; otherwise, they are not. I show that a CREE exists, that it arises naturally as the limit of adaptive and Bayesian learning, and that it incorporates a version of the Lucas critique. I then apply CREE to a particular novel form of bounded rationality where beliefs are constrained to factor models with a small number of endogenously chosen factors. Misspecification leads to amplification or dampening of shocks and history dependence. The calibrated economy exhibits hump-shaped impulse responses and co-movements in consumption, output, hours, and investment that resemble business-cycle fluctuations.

Date: 2019
New Economics Papers: this item is included in nep-dge and nep-mac
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Citations: View citations in EconPapers (38)

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