Essay on beliefs and the macroeconomy

Abstract

This thesis consists of three essays. The first essay explores a form of bounded rationality where agents learn about the economy with possibly misspecified models. I consider a recursive general-equilibrium framework that nests a large class of macroeconomic models. Misspecification is represented as a constraint on the set of beliefs agents can entertain. I introduce the solution concept of constrained-rational-expectations equilibrium (CREE), in which each agent selects the belief from her constrained set that is closest to the endogenous distribution of observables in the Kullback-Leibler divergence. If the set of permissible beliefs contains the rational-expectations equilibria (REE), then the REE are CREE; otherwise, they are not. I show that a CREE exists, that it arises naturally as the limit of adaptive and Bayesian learning, and that it incorporates a version of the Lucas critique.

I then apply CREE to a particular novel form of bounded rationality where beliefs are constrained to factor models with a small number of endogenously chosen factors. Misspecification leads to amplification or dampening of shocks and history dependence. The calibrated economy exhibits hump-shaped impulse responses and co-movements in consumption, output, hours, and investment that resemble business-cycle fluctuations. In the second essay, I ask the following question: What are the testable restrictions imposed on the dynamics of an agent's belief by the hypothesis of Bayesian rationality, which do not rely on the additional assumption that the agent has an objectively correct prior? In this paper, I argue that there are essentially no such restrictions. I consider an agent who chooses a sequence of actions and an econometrician who observes the agent's actions and is interested in testing the hypothesis that the agent is Bayesian.

I argue that--absent a priori knowledge on the part of the econometrician on the set of models considered by the agent--there are almost no observations that would lead the econometrician to conclude that the agent is not Bayesian. This result holds even if the set of actions is sufficiently rich that the agent's action fully reveals her belief about the payoff-relevant state and even if the econometrician observes a large number of identical agents facing the same sequence of decision problems. In the third essay, I propose an equilibrium search and matching model with permanent worker heterogeneity, asymmetric information, and endogenous separations and study the dynamics of adverse selection in the labor market. The interaction between asymmetric information and endogenous separations leads to a cyclical adverse selection problem that has testable predictions both for the aggregate variables and for individual workers' outcomes.

First, a deterioration in the distribution of ability in the pool of the unemployed leads firms to raise their hiring standards, thus resulting in shifting out of the Beveridge curve. Second, if the separation rate is log-supermodular (log-submodular) in productivity and ability, the pool of the unemployed becomes more (less) adversely selected in downturns. Third, firms rationally discriminate against the long-term unemployed by demanding more unequivocally positive signals of their ability before hiring them. Fourth, this scarring effect is more (less) severe for lower-ability workers and after deeper recessions if the separation rate is log-supermodular (log-submodular). I conclude by providing conditions on the fundamentals of the economy that lead to log-supermodular and log-submodular separation rates.