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Rational overconfidence and excess volatility in General Equilibrium

Author

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  • Carsten Krabbe Nielsen
Abstract
Rational beliefs (in the form of WAMS measures) are expectations which though consistent with empirical observations, may deviate from the true underlying probability measure under which data is generated.We provide results on, as well as a decomposition of, WAMS measures and use this to demonstrate that an agent that adopts a non-stationary rational belief is rationally overconfident.To apply the theory to models of general equilibrium, we introduce the concept of a sunspot rational beliefs structure which can be considered as the exogenously specified part of a state process with rational beliefs. As an application, we consider an continuous state space model where agents make production decision before knowing prices. Under rational beliefs, unlike under rational expectations, mistakes persist even though all agents make forecasts that are statistically consistent with the equilibrium process. Due to the correlation of subjective beliefs brought about by the sunspots, the equilibrium exhibits excess price volatility.

Suggested Citation

  • Carsten Krabbe Nielsen, 2004. "Rational overconfidence and excess volatility in General Equilibrium," Econometric Society 2004 Australasian Meetings 279, Econometric Society.
    • Handle: RePEc:ecm:ausm04:279
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    References listed on IDEAS

    as
    1. Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
    2. Carsten Krabbe Nielsen, 2003. "Floating exchange rates versus a monetary union under rational beliefs: the role of endogenous uncertainty," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 21(2), pages 293-315, March.
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    6. Sarno,Lucio & Taylor,Mark P., 2003. "The Economics of Exchange Rates," Cambridge Books, Cambridge University Press, number 9780521485845.
    7. repec:bla:econom:v:48:y:1981:i:191:p:235-50 is not listed on IDEAS
    8. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
    9. Dan Lovallo & Colin Camerer, 1999. "Overconfidence and Excess Entry: An Experimental Approach," American Economic Review, American Economic Association, vol. 89(1), pages 306-318, March.
    10. Carsten Krabbe Nielsen, 1996. "Rational belief structures and rational belief equilibria (*)," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 8(3), pages 399-422.
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    Cited by:

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    More about this item

    Keywords

    Rational Beliefs; Rational Overconfidence; Excess Volatility;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies

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