Inferential Expectations

Menzies, Gordon Douglas; Zizzo, Daniel John

doi:10.2139/ssrn.733123

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Inferential Expectations

UTS Quantitative Finance Research Paper No. 159

40 Pages Posted: 1 Jun 2005

See all articles by Gordon Douglas Menzies

Gordon Douglas Menzies

University of Technology Sydney (UTS) - School of Finance and Economics

Daniel John Zizzo

University of Queensland - School of Economics

Date Written: May 2005

Abstract

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

Menzies, Gordon Douglas and Zizzo, Daniel John, Inferential Expectations (May 2005). UTS Quantitative Finance Research Paper No. 159, Available at SSRN: https://ssrn.com/abstract=733123 or http://dx.doi.org/10.2139/ssrn.733123