DP13187 The permanent-transitory confusion: Implications for tests of market efficiency and for expected inflation during turbulent and tranquil times
Even when all past and present information is known individuals
usually remain uncertain about the permanence of observed
variables. After reviewing the history and role of adaptive
expectations and its statistical foundations in modeling this
permanent-transitory confusion the paper investigates the consequences
of this confusion for tests of market efficiency in the
treasury bill and foreign exchange markets. A central result is
that the detection of serial correlation in efficiency tests based on
finite samples does not necessarily imply that markets are inefficient.
The second part of the paper utilizes data on Israeli inflation
expectations from the capital market to estimate the implicit
speed of learning about changes in inflation and to examine the
performance of adaptive expectations in tracking the evolution of
those expectations during the 1985 Israeli shock stabilization as well as
during the stable inflation targeting period.