The aim of this project is to investigate the implications of extrapolative beliefs for macroeconomic stability and policy trade-offs, including monetary policy and macro-prudential regulation.
Since the Financial Crisis, there has been renewed interest in understanding asset price booms and busts and their implications for the macroeconomy. One approach in the literature has focused on models where expectations are extrapolations based on recent trends. However, there is little consensus on how such beliefs are formed and the implications for policy are not well understood.
This project aims to investigate how different types of extrapolation influence the prevalence of boom and bust cycles, and to shed light on the implications for policy – especially macro-prudential regulation of the financial sector. The consequences of different types of extrapolation will be compared using simulated models of the economy, to find out which expectations better explain asset price dynamics. Empirically supported specifications will then be used as a basis for policy analysis.
The results should provide insights into which types of beliefs are potentially de-stabilizing and how macroeconomic policy should be conducted in environments where agents’ beliefs – and hence behaviour – deviate from the benchmark assumption of rational expectations.
This project was funded by the Social Macroeconomic Hub of the ESRC’s Rebuilding Macroeconomics network.