Indeterminacy and Imperfect information

Abstract

We study equilibrium determination in an environment where two kinds of agents have different information sets: The fully informed agents know the structure of the model and observe histories of all exogenous and endogenous variables. The less informed agents observe only a strict subset of the full information set. All types of agents form expectations rationally, but agents with limited information need to solve a dynamic signal extraction problem to gather information about the variables they do not observe. In this environment, we identify a new channel that leads to equilibrium indeterminacy: Optimal information processing of the less informed agent introduces stable dynamics into the equation system that lead to self-fulling expectations. For parameter values that imply a unique equilibrium under full information, the limited information rational expectations equilibrium is indeterminate. We illustrate our framework with a monetary policy problem where an imperfectly informed central bank follows an interest rate rule.

Keywords: Limited information; rational expectations; signal extraction; belief shocks

JEL Classification: C11, C32, E52