No. 281 - Coordination and Correlation in Markov Rational Belief Equilibria
This paper studies the effect of correlation in the rational beliefs of agents on the volatility of asset prices. We use the technique of generating variables to study stable and non-stationary processes needed to characterize rational beliefs. We then examine how the stochastic interaction among such variables affects the behavior of a wide class of Rational Belief Equilibria (RBE).
The paper demonstrates how to construct a consistent price state space and then shows the existence of RBE for any economy for which such price state space is constructed. Next, the results are used to study the volatility of asset prices via numerical simulation of a two-agent model. If beliefs of agents are uniformly dispersed and independent, we would expect heterogeneity of beliefs to have a limited impact on the fluctuations of asset prices. On the other hand, our results show that correlation across agents can have a complex and dramatic effect on the volatility of prices and thus can be the dominant factor in the fluctuations of asset prices.
The mechanism generating this effect works through the clustering of beliefs in states of different levels of agreement. In states of agreement the conditional forecasts of the agents tend to fluctuate together, inducing more volatile asset prices. In states of disagreement the conditional forecasts fluctuate in diverse directions, tending to cancel each other's effect on market demand and resulting in reduced price volatility. This time variability of the variance of asset prices is consistent with the well-documented GARCH behavior of asset prices.
Presentation at a Seminar held by the authors at the Research Department of the Bank of Italy, 2-3 July 1996.
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30 October 1996
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