Macroeconomic Dynamics

Table of Contents - 1998 - Volume 2, Issue 02  


CALCULATION, ADAPTATION AND RATIONAL EXPECTATIONS

George W. Evans a1c1 1 and Garey Ramey a2
a1 University of Oregon
a2 University of California at San Diego

Abstract

We propose an active cognition approach to bounded rationality, in which agents use a calculation algorithm to improve on the forecasts provided by a purely adaptive learning rule such as least-squares learning. Agents' choices of calculation intensity depend on their estimates of the benefits of improved forecasts relative to calculation costs. Using an asset-pricing model, we show how more rapid adjustment to rational expectations and forward-looking behavior arise naturally when there are large anticipated structural changes such as policy shifts. We also give illustrative applications in which the severity of asset price bubbles and the intensity of hyperinflationary episodes are related to the cognitive ability of the agents.


Key Words: Expectations; Bounded Rationality; Active Cognition; Calculation Algorithm; Adaptation.

Correspondence:
c1 Address correspondence to: Professor George W. Evans, Department of Economics, 1285 University of Oregon, Eugene, OR 97403-1285, USA; e-mail: gevans@oregon.uoregon.edu

Footnotes

1 We are indebted to John Conlisk, Vince Crawford, Wouter den Haan, Roger Farmer, Joel Sobel and numerous seminar participants. This research was supported by NSF Grant SES-9210405.