Alternative models of expectations formation : a review and empirical tests
Date
1984
Authors
Pepper, Ron
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Abstract
Individuals formulate expectations of key economic variables and behave according to these expectations. These expectations play major roles in the effectiveness of discretionary monetary and fiscal policy. In particular, monetary and fiscal policy effectiveness depends on whether inflation rate and interest rate expectational errors are randomly distributed around their realized values, or whether the expectational errors are systematically and persistently biased. An individual's expectations of the inflation rate or interest rate are unobservable. To evaluate policy effectiveness, some assumptions have to be made concerning the nature of expectations formation. This thesis reviews the major hypotheses of expectations formation and generates empirical proxies for the inflation rate and interest rate using alternative weak-form models of expectations formation; i.e., models using information found in past values of the economic variable. The proxies generated by these models are subjected to a number of tests to determine the nature of the expectational errors and the implications for policy effectiveness. The results of the tests indicate that weak-form unconstrained or stochastic models of expectations formation, as represented by the Box and Jenkins ARIMA methodology, generate empirical proxies that are considerably more accurate and random in nature than the empirical proxies generated by constrained models or by models that are based on market determined nominal interest rates. By assuming that individuals weigh. the costs of using complex expectations models with. the benefits derived from generating accurate forecasts from these models, this thesis concludes that economic agents will use ARI.MA models in formulating actual expectations. Because expectational errors using ARIMA models are minimal and random in nature, this thesis concludes that the economic impact of government stabilization policy will be limited.