On Forecasting Heterogeneity, Irrational Exuberance, and the Multiplicity of Rational Expectations Equilibria

Abstract

This paper evaluates the role of limited rationality in an equilibrium model with indeterminacy of rational expectations. We assume a world in which a fraction of agents makes predictions via rational expectations and the other fraction follows simple rule-of-thumb schemes. For all considered cases, the co-presence of naive agents tends to reduce the possibility of sunspot equilibria. We also consider the case that some agents are systematically exuberant. Under this scenario, the effect of naive agents is reversed: bullishness may in fact destabilize markets.