Rational Expectations Models with Higher-Order Beliefs

Abstract

We develop a method of solving rational expectations models with dispersed information and dynamic strategic complementarities. In these types of models, the equilibrium outcome hinges on an infinite number of higher-order expectations which require an increasing number of state variables to keep track of. Despite this complication, we prove that the equilibrium outcome always admits a finite-state representation when the signals follow finite ARMA processes. We also provide the solution formula and characterize the endogenous propagation mechanism. We further illustrate how to use the method to derive comparative statics, to connect with evidence on expectations, and to integrate incomplete information with bounded rationality in general equilibrium.

Keywords: Higher-order expectations, dynamic complementarity, general equilibrium

JEL Classification: D8, E1