Internal Rationality, Heterogeneity, and Complexity in the New Keynesian Model

58 Pages Posted: 28 Dec 2017

See all articles by Cars H. Hommes

Cars H. Hommes

University of Amsterdam - Amsterdam School of Economics (ASE); CeNDEF; Tinbergen Institute

Robert Jump

University of the West of England (UWE) - Department of Accounting, Economics, and Finance

Paul Levine

School of Economics, University of Surrey

Date Written: December 12, 2017

Abstract

This paper studies the dynamic behaviour of a workhorse New Keynesian model in which households and firms can be fully rational or internally rational. First, we derive the model with a fixed proportion (1−n) of agents fully rational and a fixed proportion (1−n) of agents internally rational, in a similar manner to Massaro (2013). In this model, we establish two propositions. First, a decrease in the proportion of fully rational agents does not destabilise the system if the rational expectations determinacy condition for the monetary rule holds. Second, the rational expectations determinacy condition is identical to the stability condition for the model in which all agents are internally rational. We then extend the model to include predictor selection along the lines of Branch and McGough (2010). In this model, we establish two further propositions. First, the rational expectations determinacy condition ensures local determinacy and stability as the cost of being fully rational becomes infinitely negative. Second, if the model starts from a position of indeterminacy, an increase in the fixed cost of being fully rational can lead to the loss of local stability via a Hopf bifurcation. A rational route to randomness follows from this, which we explore numerically. Taken as a whole, these results indicate that complex dynamics in the internally rational New Keynesian model are closely associated with monetary policy failures. Finally, we consider the robustness of our results to changes in the monetary policy rule.

Keywords: New Keynesian behavioural model, internal rationality, heterogeneous expectations

JEL Classification: E03, E12, E32, E70, E71

Suggested Citation

Hommes, Cars H. and Jump, Robert and Levine, Paul L., Internal Rationality, Heterogeneity, and Complexity in the New Keynesian Model (December 12, 2017). Available at SSRN: https://ssrn.com/abstract=3086851 or http://dx.doi.org/10.2139/ssrn.3086851

Cars H. Hommes

University of Amsterdam - Amsterdam School of Economics (ASE) ( email )

Center for Nonlinear Dynamics in Economics and Finance
1018 WB Amsterdam
Netherlands
+31 20 525 4246 (Phone)
+31 20 525 4349 (Fax)

CeNDEF ( email )

Roetersstraat 11
Amsterdam, NL-1018WB
Netherlands

HOME PAGE: http://www1.fee.uva.nl/cendef/

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Robert Jump

University of the West of England (UWE) - Department of Accounting, Economics, and Finance ( email )

Blackberry Hill Bristol
Bristol, Avon BS16 1QY
United Kingdom

Paul L. Levine (Contact Author)

School of Economics, University of Surrey ( email )

Guildford
Surrey GU2 7XH
United Kingdom
+44 1483 259 380 Ext. 2773 (Phone)
+44 1483 259 548 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
26
Abstract Views
185
PlumX Metrics