The conventional approach in macroeconomics assumes that economic agents understand how market variables respond to different shocks, this is the full information Rational Expectations hypothesis (FIRE or RE). But in practice, financial investors and policy authorities have to make decisions with only partial knowledge about the economy. For example, standing in 2022, how could we know if the high inflation of that year was going to be a permanent or transitory phenomenon? How can a policy authority know if if it is influencing long or short run inflation?, This project is about economic agents acting under partial knowledge about the economy, be it in for policy makers influencing whole economies, investors in the huge US or Chinese stock markets, or farmers in a small village in Malawi.
We have been developing two methods to address these issues. First, a framework where consumers or investors learn about the economy, we call this Internally Rational (IR) learning. Second, Optimal Signal Extraction (OSE) allows to find the best policy when the government only has partial knowledge about the economy. In addition we have also done several applications more in line with the standard paradigm that serve as a reference.
IR considers investors who have a view about how stock prices are formed and they behave optimally given this knowledge. In this project we develop this concept in several ways: we extend the analysis to bond prices, option prices and business cycle models. We test the model using actual prices and survey data on expectations about bond yields, wage expectations, stock prices and inflation. We find that our approach to expectation formation helps to understand many aspects of the data. We study investors that have heterogeneous views about future market returns (disagreement), the secular evolution of the stock market, the dissemination of information through networks, the Chinese stock market, informal economy, heterogeneity in capital and labor income, preference heterogeneity, etc. both from an empirical and theoretical point of view.
The conventional approach justifies the so- called efficient market hypothesis, implying that policy interventions in asset markets are undesirable as they would only disrupt the allocation of investments. But if investors learn about prices monetary and macroprudential policy should take into account how expectations influence stock prices. Also, any policy reform needs to consider how expectations respond to policy, even more so when the population is heterogeneous.
