Working Paper: CEPR ID: DP13187
Authors: Alex Cukierman; Thomas Lustenberger; Allan H. Meltzer
Abstract: Even when all past and present information is known individualsusually remain uncertain about the permanence of observedvariables. After reviewing the history and role of adaptiveexpectations and its statistical foundations in modeling thispermanent-transitory confusion the paper investigates the consequencesof this confusion for tests of market efficiency in thetreasury bill and foreign exchange markets. A central result isthat the detection of serial correlation in efficiency tests based onfinite samples does not necessarily imply that markets are inefficient.The second part of the paper utilizes data on Israeli inflationexpectations from the capital market to estimate the implicitspeed of learning about changes in inflation and to examine theperformance of adaptive expectations in tracking the evolution ofthose expectations during the 1985 Israeli shock stabilization as well asduring the stable inflation targeting period.
Keywords: Permanent-transitory confusion; Rational expectations; Tests of market efficiency; Treasury bills; Forex markets; Behavior of inflationary expectations
JEL Codes: E31; G14; B16; B22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| permanent-transitory confusion (J63) | market efficiency tests (G14) |
| adaptive expectations (D84) | inflation expectations (E31) |
| turbulent economic conditions (E32) | adaptive expectations (D84) |
| stable inflation targeting (E63) | deviations from target (E61) |
| permanent-transitory confusion (J63) | serial correlation in market efficiency tests (C22) |