Internal Rationality, Learning and Imperfect Information

55 Pages Posted: 27 Dec 2017

See all articles by Szabolcs Deak

Szabolcs Deak

University of Surrey

Paul Levine

School of Economics, University of Surrey

Joe Pearlman

City University London

Bo Yang

Swansea University

Date Written: December 12, 2017

Abstract

We construct, estimate and explore the monetary policy consequences of a New Keynesian (NK) behavioural model with bounded-rationality and heterogeneous agents. We radically depart from most existing models of this genre in our treatment of bounded rationality and learning. Instead of the usual Euler learning approach, we assume that agents are internally rational (IR) given their beliefs of aggregate states and prices. The model is inhabited by fully rational (RE) and IR agents where the latter use simple heuristic rules to forecast aggregate variables exogenous to their micro-environment. We find that IR results in an NK model with more persistence and a smaller policy space for rule parameters that induce stability and determinacy. In the most general form of the model, agents learn from their forecasting errors by observing and comparing them with those under RE making the composition of the two types endogenous. In a Bayesian estimation with fixed proportions of RE and IR agents and a general heuristic forecasting rule we find that a pure IR model fits the data better than the pure RE case. However, the latter with imperfect rather than the standard perfect information assumption outperforms IR (easily) and RE-IR composites (slightly), but second moment comparisons suggest that the RE-IR composite can match data better. Our findings suggest that Kalman-filtering learning with RE can match bounded-rationality in matching persistence seen in the data.

Keywords: New Keynesian Behavioural Model, Internal Rationality, Heterogeneous Expectations, Reinforcement Learning, Imperfect Information

JEL Classification: E03, E12, E32

Suggested Citation

Deak, Szabolcs and Levine, Paul L. and Pearlman, Joe and Yang, Bo, Internal Rationality, Learning and Imperfect Information (December 12, 2017). Available at SSRN: https://ssrn.com/abstract=3091876 or http://dx.doi.org/10.2139/ssrn.3091876

Szabolcs Deak

University of Surrey ( email )

Guildford
Guildford, Surrey GU2 7XH
United Kingdom
1483682782 (Phone)
1483682782 (Fax)

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)

Joe Pearlman

City University London ( email )

Northampton Square
London, EC1V OHB
United Kingdom

Bo Yang

Swansea University ( email )

Singleton Park
Swansea, Wales SA2 8PP
United Kingdom

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