DP2882 Robustness of Adaptive Expectations as an Equilibrium Selection Device

Author(s): Martin Lettau, Timothy Van Zandt
Publication Date: July 2001
Keyword(s): adaptive expectations, inflation, stability
JEL(s): D84, E31
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2882

Dynamic models in which agents' behaviour depends on expectations of future prices or other endogenous variables can have steady states that are stationary equilibria for a wide variety of expectations rules, including rational expectations. When there are multiple steady states, stability is a criterion for selecting predictions of long-run outcomes among them. The purpose of this Paper is to study how sensitive stability is to certain details of the expectations rules, in a simple OLG model with constant government debt that is financed through seigniorage. We compare simple recursive learning rules, learning rules with vanishing gain, and OLS learning, and also relate these to expectational stability. One finding is that two adaptive expectation rules that differ only in whether they use current information can have opposite stability properties.