Working Paper No. 448
By Richard Harrison and Tim Taylor
In this paper, we compare two approaches to modelling behaviour under non-rational expectations in a benchmark New Keynesian model. The ‘Euler equation’ approach modifies the equations derived under the assumption of rational expectations by replacing the rational expectations operator with an alternative assumption about expectations formation. The ‘long-horizon’ expectations approach solves the decision rules of households and firms conditional on their expectations for future events that are outside of their control, so that spending and price-setting decisions depend on expectations extending into the distant future. Both approaches can be defended as descriptions of (distinct) forms of boundedly rational behaviour, but have different implications both for the form of the equations that govern the dynamics of the economy and the ease of deriving those equations. In this paper we construct two versions of a benchmark New Keynesian model in which non-rational expectations are modelled using the Euler equation and long-horizon approaches and show that both approaches have very similar implications for macroeconomic dynamics when departures from rational expectations are relatively small. But as expectations depart further from rationality, the two approaches can generate significantly different implications for the behaviour of key variables.