Proposal Title: Modeling the Evolution of Agents' Beliefs and Uncertainty in General Equilibrium Models (Proposal Number: SES - 1227397) Principal Investigator: Bianchi, Francesco
The objective of this research agenda is to study the evolution of private sector beliefs and uncertainty in general equilibrium models. The central insight is that the evolution of agents' beliefs can be captured by defining a set of regimes that are characterized by the degree of agents' pessimism, optimism, and uncertainty about future equilibrium outcomes. Once this type of structure is imposed, it is possible to create a mapping between the evolution of agents' beliefs and observable outcomes. The proposed approach goes beyond the assumption of anticipated utility, as agents know that they do not know and form expectations taking into account that their beliefs will evolve according to what they will observe. The research agenda will deliver methods to solve, simulate, and estimate structural models in which forward-looking and fully rational agents are subject to waves of pessimism, optimism, and uncertainty that turn out to critically affect macroeconomic outcomes. Such outbursts of pessimism, optimism, and uncertainty may happen abruptly or may gradually unfold over a long period of time in response to the behavior of other agents, the realizations of economic outcomes, public signals, or policy announcements. The technical details are described in the first research project, Modeling the Evolution of Public Expectations and Uncertainty. The evolution of agents' beliefs is modeled assuming the existence of different states of the world that differ according to the statistical properties of the exogenous shocks or based on the behavior of some of the agents in the model. Such regimes follow a Markov switching process, which may be correlated with other aspects of the model. Agents are assumed to observe economic outcomes, but not the regimes themselves. Instead, they have to adopt Bayesian learning to infer the regime in place. This determines a progressive evolution of agents' beliefs that translates into a drift of economic outcomes, macroeconomic volatility, and agents' uncertainty. In the second project, Dormant Shocks and Fiscal Virtue, these new methods are employed to characterize an economy in which market participants try to assess the sustainability of public debt. It is highly unlikely that the private sector knows with certainty how policy-makers will behave in the future. Different governments have different preferences about the size of the public sector and fiscal policy making is a process whose outcome is highly unpredictable. In the model, the standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a central bank that has full control over inflation. When policy-makers deviate from this virtuous policy mix, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the Virtuous Regime and inflation starts moving to keep debt on a stable path. Shocks which were dormant under the virtuous policy mix now start manifesting themselves. These changes are initially imperceptible, can unfold over decades, and accelerate as agents become convinced that the fiscal authority will not raise taxes. The new modeling framework allows for gradual changes in agents' beliefs about government's willingness to repay its debt. Therefore, the standard distinction between Ricardian and non-Ricardian regimes typical of the Fiscal Theory of Price Level breaks down. In its stead, a continuum of regimes reflecting agents' beliefs about the future behavior of policy-makers arises. How quickly agents? beliefs evolve depends on the country's Fiscal Virtue, captured by the frequency with which the country engages in long lasting deviations from the Virtuos Regime. Thus, the model is able to explain why the relation between fiscal discipline and the macroeconomy is not stable across countries and over time. When a Virtuous regime prevails or agents are confident that it will prevail in the future, the level of debt is substantially irrelevant. However, if agents become convinced that the economy entered a long lasting deviation, then interest rate and inflation differentials open up. A larger difference in Fiscal Virtue across countries leads to a larger difference in the speed of learning, which in turn speeds up the opening of the inflation and interest rate differentials. The sluggish adjustment of public expectations to policy actions described above is hard to reproduce through rational expectations models in which the functioning of the whole model economy is common knowledge among private agents. For instance, despite the dramatic widening of the balance sheet of the Federal Reserve Bank, public expectations about long-run inflation expectations have hardly moved in the last five years. In the third project, Inflationary Sentiments and Monetary Policy Communication, it is shown that this can be the result of the central bank's reputation built up over the years. In the model, monetary policy alternates periods of active inflation stabilization (Active Regime) and periods during which the emphasis is mainly on output stabilization (Passive Regime). When the central bank engages in only short lasting deviations from the Active Regime, inflation expectations always remain anchored and the model captures the monetary approach described by the Fed Chairman Ben Bernanke as constrained discretion. However, if the central bank deviates for a prolonged period of time, inflationary sentiments progressively spread among agents. The model is fit to U.S. data to show that increasing the transparency of the Federal Reserve improves welfare by anchoring inflationary sentiments. Gains from transparency are even more sizeable for countries whose central bank has failed to establish a strong reputation for inflation stability.
