Recursive equilibria in dynamic economies with bounded rationality

28 Pages Posted: 5 May 2021

See all articles by Runjie Geng

Runjie Geng

University of Zurich - Department of Banking and Finance

Ally Zhang

Department of Finance, Lancaster University Management School; Swiss Finance Institute

Date Written: April 30, 2021

Abstract

This paper provides a general framework to model bounded rationality in dynamic stochastic general equilibrium models with infinitely lived heterogeneous agents. A boundedly rational agent is associated with an information set $I$ and an extra parameter $\epsilon$, which can be interpreted as the ``level of irrationality''. To make decisions, the boundedly rational agent forms a belief of a stationary joint distribution of the exogenous and endogenous variables and uses the marginal distribution (conditional on $I$) to form forecasts. If the equilibrium distribution stays within $\epsilon$ of the forecasted next-period distribution, the agent would consider it as $\epsilon$-stationary. In equilibrium, each agent maximizes utility with an $\epsilon$-stationary belief and markets clear. The main theorem of this paper shows that for any strictly positive $\epsilon$, a recursive equilibrium exists. With a quantifiable ``level of irrationality'', the model incorporates many behavioral economics models as well as rational-expectations models with computational approximations into a unified framework. An illustration example is presented to show that the boundedly rational recursive equilibrium may substantially enrich the asset pricing dynamics of the rational-expectations model even for small $\epsilon$.

Keywords: bounded rationality, recursive equilibria, behavioral economics, asset pricing

JEL Classification: D51, D52, D53, D58

Suggested Citation

Geng, Runjie and Zhang, Quan, Recursive equilibria in dynamic economies with bounded rationality (April 30, 2021). Available at SSRN: https://ssrn.com/abstract=3837485 or http://dx.doi.org/10.2139/ssrn.3837485

Runjie Geng

University of Zurich - Department of Banking and Finance ( email )

Sch├Ânberggasse 1
Z├╝rich, 8001
Switzerland

Quan Zhang (Contact Author)

Department of Finance, Lancaster University Management School ( email )

Economics Department,
LUMS,
Bailrigg Lancaster, LA1 4YX
United Kingdom
+441524592776 (Phone)

HOME PAGE: http://www.allyquanzhang.com/wordpress/

Swiss Finance Institute ( email )

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Zurich, ZH 8032
Switzerland

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