Working Paper Series no. 402: Good Luck or Good Policy? An Expectational Theory of Macro-Volatility Switches

Abstract

In an otherwise unique-equilibrium model, agents are segmented into a few informational islands according to the signal they receive about others' expectations. Even if agents perfectly observe fundamentals, rational-exuberance equilibria (REX) can arise as they put weight on expectational signals to refine their forecasts. Constant-gain adaptive learning can trigger jumps between the equilibrium where only fundamentals are weighted and a REX. This determines regime switching in macro volatility despite unchanged monetary policy and time-invariant distribution of exogenous shocks. In this context, a tight inflation-targeting policy can lower expectational complementarity preventing rational exuberance, although its effect is non-monotone.

Gaetano Gaballo
October 2012

Classification JEL : E3, E5, D8.

Keywords : non-fundamental volatility; perpetual learning; comovements in expectations; professional forecasters.