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American Economic Review: Vol. 101 No. 6 (October 2011)

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Expectations, Learning, and Business Cycle Fluctuations

Article Citation

Eusepi, Stefano, and Bruce Preston. 2011. "Expectations, Learning, and Business Cycle Fluctuations." American Economic Review, 101(6): 2844-72.

DOI: 10.1257/aer.101.6.2844

Abstract

This paper develops a theory of expectations-driven business cycles based on learning. Agents have incomplete knowledge about how market prices are determined and shifts in expectations of future prices affect dynamics. Learning breaks the tight link between fundamentals and equilibrium prices, inducing periods of erroneous optimism or pessimism about future returns to capital and wages which subsequent data partially validate. In a real business cycle model, the theoretical framework amplifies and propagates technology shocks. Moreover, it produces agents' forecast errors consistent with business cycle properties of forecast errors for a wide range of variables from the Survey of Professional Forecasters. (JEL C53, D83, D84, E32, E37)

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Authors

Eusepi, Stefano (Federal Reserve Bank of New York)
Preston, Bruce (Columbia U and Center for Applied Macroeconomic Analysis, Australian National U)

JEL Classifications

C53: Forecasting Methods; Simulation Methods
D83: Search; Learning; Information and Knowledge; Communication; Belief
D84: Expectations; Speculations
E32: Business Fluctuations; Cycles
E37: Prices, Business Fluctuations, and Cycles: Forecasting and Simulation: Models and Applications


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