Volatility as a Choice
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Abstract
Human beliefs, while always remaining in equilibrium, serve as an equilibrium selector and determine the degree of aggregate volatility. Fully rational and risk averse economic agents expect macro-level dynamics to be characterised by a specific degree of volatility. Given this expectation the agents respond rationally by building up higher buffer stock savings in response to perceived volatility. The economy, given the change in individual behaviour, responds, the process of physical capital formation is endogenously altered, and it displays volatility that is in line with the initial expectation of rational economic agents. As a result, the beliefs, while being self-confirming, determine endogenously the degree of volatility at the aggregate level.(original abstract)
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References
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