In our current research, we study expectations and choices of agents who do not (fully) understand the economic environment that they live in. Agents form “mental models” of the economy based on historical experience, and influenced by a societal belief formation process that may also be partly shaped by interested parties. Agents use these mental models for forming expectations about exogenous and endogenous variables and for making forward-looking choices. These choices feed back into the economic system. If the mental models turn out to deviate significantly from developments in the underlying reality, this may lead to a “model adjustment shock”. We are interested in modeling various aspects of the described dynamics, how they affect dynamic patterns in macroeconomic and microeconomic time series, and how they are related to the emergence of crises.
The following papers are part of this research program:
We consider an agent who does not know the data-generating process (DGP) of the economic environment but observes past outcomes. Moreover, the agent considers it possible that the DGP changes in unpredictable ways. In this setting – which we refer to as one of fundamental uncertainty – standard optimal intertemporal choice is not feasible. We provide a model in which the agent makes forward-looking decisions using a future value function that does not depend on any specific information about a DGP. The agent makes forecasts about a subsequent period based on historical analogies. Specifically, we consider the consumption and asset holding decision of a representative agent who earns an exogenous stream of labor income. We calibrate the model to aggregate US data. Despite its simplicity, the model captures the relevant empirical patterns better than a rational expectations model with a comparable degree of flexibility.
Successful innovations are a key driver of long-run economic growth. In practice, potential innovations come with a great deal of uncertainty, i.e., a dearth of objective information on the likelihood of eventual success or failure. We present a tractable growth model in which entrepreneurs are characterized by their openness to novelty. Greater openness makes it more likely that, against the backdrop of uncertainty, potential innovations are checked out; but greater openness can also lead to exuberance, to negative signs being ignored – and then to misallocation and crisis-induced paralysis. We analyze this trade-off and show that it implies a hump-shaped relationship between openness and long-run growth. The calibrated model predicts that over a significant part of the range the negative effect of openness dominates, a result we show to be consistent with the empirical pattern. On the other hand, the calibrated model suggests that heterogeneity in entrepreneurial openness to novelty helps growth. The magnitude of the effect is sizable.
Periodically, economies produce potentially transformative innovations, but the required investments are fraught with large uncertainties. Initially, objective information for predicting their success is scarce. How then do investors form subjective beliefs about prospective returns? We explore the role of competing financial intermediaries that channel funds either to firms in the innovation sector or to firms potentially displaced by the innovation. In our model, investors’ subjective beliefs emerge from a competitive campaign game, or belief contest, between financial intermediaries. A regulator who does not possess superior knowledge may want to tilt beliefs away from "exuberance'' or "pessimism'' towards "impartiality''.
Introducing the concept of “belief entrepreneur”, this paper offers a novel framework of endogenous belief formation under fundamental uncertainty. We consider a generic setup in which individuals must choose between a tested approach (supplied by a “defender”) and a competing innovative approach (supplied by an “innovator”). While the innovation is promising, its true merits are uncertain. Facing an ambiguous choice, individuals turn to heuristic belief formation. As a result, beliefs become contested quantities that arise in a game between the innovator and defender who act as competing belief entrepreneurs. We clarify the conditions under which the contest outcome predominantly reflects information on the merits of the innovation – and when other factors, such as the entrepreneurs' payoffs, dominate. Our analysis may be helpful to policy makers who have to assess uncertain innovations whose spread is propelled by highly favorable beliefs.