Internal Rationality, Imperfect Market Knowledge and Asset Prices

We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be 'externally rational', i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors' expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents' market knowledge.learning, internal rationality, consumption based asset pricing

Booms and Busts in Asset Prices

We show how low-frequency boom and bust cycles in asset prices can emerge from Bayesian learning by investors. Investors rationally maximize infinite horizon utility but hold subjective priors about the asset return process that we allow to differ infinitesimally from the rational expectations prior. Bayesian updating of return beliefs then gives rise to selfreinforcing return optimism that results in an asset price boom. The boom endogenously comes to an end because return optimism causes investors to make optimistic plans about future consumption. The latter reduces the demand for assets that allow to intertemporally transfer resources. Once returns fall short of expectations, investors revise return expectations downward and set in motion a self-reinforcing price bust. In line with available survey data, the learning model predicts return optimism to comove positively with market valuation. In addition, the learning model replicates the low frequency behavior of the U.S. price dividend ratio over the period 1926-2006.asset price fluctuations, boom and bust cycles

Recursive Contracts

We obtain a recursive formulation for a general class of contracting problems involving incentive constraints. These constraints make the corresponding maximization (sup) problems non recursive. Our approach consists of studying a recursive Lagrangian. Under standard general conditions, there is a recursive saddle-point (infsup) functional equation (analogous to a Bellman equation) that characterizes the recursive solution to the planner's problem and forward-looking constraints. Our approach has been applied to a large class of dynamic contractual problems, such as contracts with limited enforcement, optimal policy design with implementability constraints, and dynamic political economy models.Transactional relationships, contracts and reputation, recursive formulation,participation constraint

Debt and Deficit Fluctuations and the Structure of Bond Markets

We analyse the implications of optimal taxation for the stochastic behaviour of debt. We show that when a government pursues an optimal fiscal policy under complete markets, the value of debt has the same or less persistence than other variables in the economy and it declines in response to shocks that cause the deficit to increase. By contrast, under incomplete markets debt shows more persistence than other variables and it increases in response to shocks that cause a higher deficit. Data for US government debt reveals diametrically opposite results from those of complete markets and is much more supportive of bond market incompleteness.Complete vs incomplete markets, Debt Management, Fiscal

Booms and Busts in Asset Prices

We show how low-frequency boom and bust cycles in asset prices can emerge from Bayesian learning by investors. Investors rationally maximize infinite horizon utility but hold subjective priors about the asset return process that we allow to differ infinitesimally from the rational expectations prior. Bayesian updating of return beliefs then gives rise to self-reinforcing return optimism that results in an asset price boom. The boom endogenously comes to an end because return optimism causes investors to make optimistic plans about future consumption. The latter reduces the demand for assets that allow to intertemporally transfer resources. Once returns fall short of expectations, investors revise return expectations downward and set in motion a self-reinforcing price bust. In line with available survey data, the learning model predicts return optimism to comove positively with market valuation. In addition, the learning model replicates the low frequency behavior of the U.S. price dividend ratio over the period 1926-2006.

Money and prices in models of bounded rationality in high inflation economies

This paper studies the short run correlation of inflation and money growth. We study whether a model of learning can do better than a model of rational expectations, we focus our study on countries of high inflation. We take the money process as an exogenous variable, estimated from the data through a switching regime process. We find that the rational expectations model and the model of learning both offer very good explanations for the joint behavior of money and prices.Inflation and money growth, switching regimes, quasi-rationality

Incomplete Markets, Labor Supply and Capital Accumulation.

Endogenous labor supply decisions are introduced in an equilibrium model of limited insurance against idiosyncratic shocks. Unlike in the standard case with exogenous labor (e.g. [Aiyagari, S.R., 1994. Uninsured idiosyncratic risk and aggregate saving. Quarterly Journal of Economics 109, 659–684; Huggett, M., 1997. The one-sector growth model with idiosyncratic shocks: steady states and dynamics. Journal of Monetary Economics 39, 385–403]), labor supply is likely to be lower than under complete markets. This is due to an ex post wealth effect on labor supply (rich productive agents work fewer hours) that runs counter the precautionary savings motive. As a result, equilibrium savings and output may be lower under incomplete markets. It is also found that long-run savings remain finite even when the interest rate equals the inverse of the discount factor.diosyncratic shocks;Incomplete markets;Labor supply;

The HP-filter in cross-country comparisons

Many empirical studies of business cycles have followed the practise of applying the Hodrick-Prescott filter for cross-country comparisons. The standard procedure is to set the weight \lambda, which determines the 'smoothness' of the trend equal to 1600. We show that if this value is used for against common wisdom about business cycles. As an example, we show that the long recession occurred inSpain between 1975 and 1985 goes unnotoced by the HP filter. We propose a method for adjusting \lambda by reinterpreting the HP-filter as the solution to a constrained minimization problem. We argue that the common practice of fixing \lambda across countries amounts to chankging the constraints on trend variability across countries. Our proposed method is easy to apply, retains all the virtues of the standard HP-filter and when applied to Spanish data the results are in the line with economic historian's view. Applying the method to a number of OECD countries we find that, with the exception of Spain, Italy and Japan, the standard choice of \lambda=1600 is sensible.Business cycles, cross-country comparisons, macroeconomic volatility

In Search of a Theory of Debt Management

A growing literature integrates debt management into models of optimal fiscal policy. One promising theory argues the composition of government debt should be chosen so that fluctuations in its market value offsets changes in expected future deficits. This complete market approach to debt management is valid even when governments only issue non-contingent bonds. Because bond returns are highly correlated it is known this approach implies asset positions which are large multiples of GDP. We show, analytically and numerically, across a wide range of model specifications (habits, productivity shocks, capital accumulation, persistent shocks, etc) that this is only one of the weaknesses of this approach. We find evidence of large fluctuations in positions, enormous changes in portfolios for minor changes in maturities issued and no presumption it is always optimal to issue long term debt and invest in short term assets. We show these extreme, volatile and unstable features are undesirable from a practical perspective for two reasons. Firstly the fragility of the optimal portfolio to small changes in model specification means it is frequently better for fear of model misspecification to follow a balanced budget rather than issue the optimal debt structure. Secondly we show for even miniscule levels of transaction costs governments would prefer a balanced budget rather than the large and volatile positions the complete market approach recommends. We conclude it is difficult to insulate fiscal policy from shocks using the complete markets approach. Due to the yield curve's limited variability maturities are a poor way to substitute for state contingent debt. As a result the recommendations of this approach conflict with a number of features we believe are integral to bond market incompleteness e.g. allowing for transaction costs, liquidity effects, robustness etc. Our belief is that market imperfections need to be explicitly introduced into the model and incorporated into the portfolio problem. Failure to do so means that the complete market approach applied in an incomplete market setting can be seriously misleading.Complete markets, debt management, government debt, maturity structure, yield curve