Tests for bounded rationality with a linear dynamic model distorted by heterogeneous expectations

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Abstract

The purpose of this paper is to develop a methodology which will use economic data to detect the existence of boundedly rational economic agents. The bounded rationality model presented in this paper generalizes a linear dynamic rational expectations model by nesting two types of expectations. In this paper, it is claimed that the bounded rationality model as presented can be transformed into an optimal regulator problem with distortions. As a result, the methodologies developed by the optimal control theory can be used to solve the model. The likelihood function for the model is constructed by the Kalman filtering using the solution of the model. Maximum Likelihood Estimation (MLE) is performed to test for bounded rationality in the U.S. cattle market for the period from 1900 to 1990. The empirical results indicate that some fraction of economic agents in the market are boundedly rational.

Original languageEnglish
Pages (from-to)1517-1543
Number of pages27
JournalJournal of Economic Dynamics and Control
Volume23
Issue number9-10
DOIs
Publication statusPublished - 1999 Sep
Externally publishedYes

Keywords

  • Bounded rationality
  • Heterogeneous expectations
  • Kalman filtering
  • Maximum likelihood estimation
  • Optimal regulator problem with distortions

ASJC Scopus subject areas

  • Economics and Econometrics
  • Control and Optimization
  • Applied Mathematics

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