UTS Quantitative Finance Research Paper No. 159
40 Pages Posted: 1 Jun 2005
Date Written: May 2005
We propose that the formation of beliefs be treated as statistical hypothesis tests, and we label such beliefs inferential expectations. If a belief is overturned through the build-up of evidence, agents are assumed to switch to the rational expectation. Rational expectations are shown to be a special (limiting) case of inferential expectations, with the test size alpha becoming a metric for rationality. When inferential expectations are built into a Dornbusch-style model of the exchange rate, regression tests of Uncovered Interest Parity and the rational expectations version of the term structure both display downward bias in the slope coefficient. We present the results of an experiment that supports inferential expectations.
Keywords: expectations, macroeconomics, rationality, uncovered interest parity, term structure, exchange rate
JEL Classification: C91, D84, E50, F31
Suggested Citation: Suggested Citation