Working Paper: NBER ID: w29776
Authors: Georgemarios Angeletos; Chen Lian
Abstract: We review how realistic frictions in information and/or rationality arrest general equilibrium (GE) feedbacks. In one specification, we maintain rational expectations but remove common knowledge of aggregate shocks. In another, we replace rational expectations with Level-k Thinking or a smooth variant thereof. Two other approaches, heterogeneous priors and cognitive discounting, capture the same essence while offering a gain in tractability. Relative to the full-information rational-expectation (FIRE) benchmark, all these modifications amount to attenuation of GE effects, especially in the short run. This in turn translates to either under- or over-reaction in aggregate outcomes, depending on whether GE feedbacks are positive or negative in the first place. We review a few applications, with emphasis on monetary and fiscal policy. We finally discuss how the available evidence on expectations, along with other considerations, can help guide the choice among the various alternatives, as well as between them and FIRE.
Keywords: General Equilibrium; Incomplete Information; Bounded Rationality; Expectations; Monetary Policy; Fiscal Policy
JEL Codes: D8; E1; E3; E7
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| frictions in information and rationality (D83) | general equilibrium feedbacks (D50) |
| removing common knowledge of aggregate shocks (D89) | lower perceived GE feedbacks (F69) |
| replacing rational expectations with level-k thinking (D84) | underestimating the sophistication of others (D80) |
| underestimating the sophistication of others (D80) | attenuates GE feedbacks (D58) |
| heterogeneous priors (D80) | nuanced understanding of how depth of knowledge affects rationality (D80) |
| cognitive discounting (D91) | underextrapolation (C51) |
| modifications to FIRE benchmark (G28) | underreaction or overreaction in aggregate outcomes (G41) |