Working Paper: CEPR ID: DP8892
Authors: George W. Evans; Seppo Honkapohja; Kaushik Mitra
Abstract: What is the impact of surprise and anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations? We examine this issue using the standard stochastic real business cycle model with lump-sum taxes. Agents combine knowledge about future policy with econometric forecasts of future wages and interest rates. Both permanent and temporary policy changes are analyzed. Dynamics under learning can have large impact effects and a gradual hump-shaped response, and tend to be prominently characterized by oscillations not present under rational expectations. These fluctuations reflect periods of excessive optimism or pessimism, followed by subsequent corrections.
Keywords: expectations; government spending; permanent and temporary policy change; taxation
JEL Codes: D84; E21; E43; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Policy changes (J18) | Expectations about future wages and interest rates (D84) |
| Expectations about future wages and interest rates (D84) | Oscillatory dynamics in consumption, labor supply, and output (E21) |
| Policy changes (J18) | Oscillatory dynamics in consumption, labor supply, and output (E21) |
| Government spending (H59) | Consumption (E21) |
| Government spending (H59) | Output (Y10) |
| Expectations about future wages and interest rates (D84) | Overoptimism and corrections in agents' expectations (D84) |
| Learning dynamics (C69) | Systematic wave of optimism or pessimism (E32) |