DP8917 Bayesian Model Averaging, Learning and Model Selection

Author(s): George W. Evans, Seppo Honkapohja, Thomas J Sargent, Noah Williams
Publication Date: March 2012
Keyword(s): grain of truth, rational expectations equilibrium, Time-varying perceptions
JEL(s): D83, D84, E37
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8917

Agents have two forecasting models, one consistent with the unique rational expectations equilibrium, another that assumes a time-varying parameter structure. When agents use Bayesian updating to choose between models in a self-referential system, we find that learning dynamics lead to selection of one of the two models. However, there are parameter regions for which the non-rational forecasting model is selected in the long-run. A key structural parameter governing outcomes measures the degree of expectations feedback in Muth's model of price determination.