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Internal Rationality and Asset Prices

Author

Listed:
  • Marcet, Albert
  • Adam, Klaus
Abstract
We present a decision theoretic framework with agents that are learning about the behavior of market determined variables. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given consistent beliefs about the future, but may not be 'externally rational', i.e., may not know the true stochastic process for market determined variables (asset prices) and fundamentals (dividends). We apply this approach to a simple asset pricing model with heterogeneity and incomplete markets. We show how knowledge about dividends and optimal behavior alone fail to fully inform agents about equilibrium prices, so that learning about price behavior, as in Adam, Marcet and Nicolini (2008), is fully consistent with internal rationality. We also show that equilibrium prices depend on expectations of the discounted price and dividend in the next period only, rather than on the expected discounted sum of future dividends. Discounted sums emerge only after making very strong assumptions about agents' knowledge and prove extremely sensitive to the details about agents' prior beliefs about the dividend process.

Suggested Citation

  • Marcet, Albert & Adam, Klaus, 2009. "Internal Rationality and Asset Prices," CEPR Discussion Papers 7498, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:7498
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    References listed on IDEAS

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    2. Krisztina Molnár & Sergio Santoro, 2006. "Optimal Monetary Policy When Agents Are Learning," CERS-IE WORKING PAPERS 0601, Institute of Economics, Centre for Economic and Regional Studies, revised 15 Mar 2006.
    3. Stefano Eusepi & Bruce Preston, 2011. "Expectations, Learning, and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 101(6), pages 2844-2872, October.
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    Cited by:

    1. Klaus Adam & Albert Marcet, 2010. "Booms and Busts in Asset Prices," IMES Discussion Paper Series 10-E-02, Institute for Monetary and Economic Studies, Bank of Japan.
    2. Hommes, Cars & Zhu, Mei, 2014. "Behavioral learning equilibria," Journal of Economic Theory, Elsevier, vol. 150(C), pages 778-814.

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    More about this item

    Keywords

    Learning; Rationality;

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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