Rational overconfidence and excess volatility in General Equilibrium

Carsten Nielsen

No 279, Econometric Society 2004 Australasian Meetings from Econometric Society

Abstract: Rational beliefs (in the form of WAMS measures) are expectations which though consistent with empirical observations, may deviate from the true underlying probability measure under which data is generated.We provide results on, as well as a decomposition of, WAMS measures and use this to demonstrate that an agent that adopts a non-stationary rational belief is rationally overconfident.To apply the theory to models of general equilibrium, we introduce the concept of a sunspot rational beliefs structure which can be considered as the exogenously specified part of a state process with rational beliefs. As an application, we consider an continuous state space model where agents make production decision before knowing prices. Under rational beliefs, unlike under rational expectations, mistakes persist even though all agents make forecasts that are statistically consistent with the equilibrium process. Due to the correlation of subjective beliefs brought about by the sunspots, the equilibrium exhibits excess price volatility.

Keywords: Rational Beliefs; Rational Overconfidence; Excess Volatility (search for similar items in EconPapers)
JEL-codes: D51 D61 (search for similar items in EconPapers)
Date: 2004-08-11
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Working Paper: Rational overconfidence and excess volatility in general equilibrium (2004)
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