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A new approach to the rational expectations equilibrium: existence, optimality and incentive compatibility

Luciano I. Castro (), Marialaura Pesce () and Nicholas C. Yannelis ()
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Luciano I. Castro: The University of Iowa
Nicholas C. Yannelis: The University of Iowa

Annals of Finance, 2020, vol. 16, issue 1, No 1, 61 pages

Abstract: Abstract Rational expectations equilibrium seeks a proper treatment of behavior under private information by assuming that the information revealed by prices is taken into account by consumers in their decisions. Typically agents are supposed to maximize a conditional expectation of state-dependent utility function and to consume the same bundles in indistiguishable states [see Allen (Econometrica 49(5):1173–1199, 1981), Radner (Econometrica 47(3):655–678, 1979)]. A problem with this model is that a rational expectations equilibrium may not exist even under very restrictive assumptions, may not be efficient, may not be incentive compatible, and may not be implementable as a perfect Bayesian equilibrium (Glycopantis et al. in Econ Theory 26(4):765–791, 2005). We introduce a notion of rational expectations equilibrium with two main features: agents may consume different bundles in indistinguishable states and ambiguity is allowed in individuals’ preferences. We show that such an equilibrium exists universally and not only generically without freezing a particular preferences representation. Moreover, if we particularize the preferences to a specific form of the maxmin expected utility model introduced in Gilboa and Schmeidler (J Math Econ 18(2):141–153, 1989), then we are able to prove efficiency and incentive compatibility. These properties do not hold for the traditional (Bayesian) Rational Expectation Equilibrium.

Keywords: Rational expectations; Ambiguity aversion; Efficiency; Incentive compatibility (search for similar items in EconPapers)
JEL-codes: D50 D81 D82 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1007/s10436-019-00349-w

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