# 13-206/II (2013-12-17)

Author(s)
Cars Hommes, University of Amsterdam
Keywords:
Expectation feedback, self-fulfilling beliefs, heuristic switching model, experimental macroeconomics
JEL codes:
D84, D83, E32, C92

This discussion paper led to a publication in the 'Journal of Economic Methodology', 20(4), 2013.

We discuss recent work on bounded rationality and learning in relation to Soros' principle of reflexivity and stress the empirical importance of non-rational, almost self-fulfilling equilibria in positive feedback systems. As an empirical example, we discuss a behavioral asset pricing model with heterogeneous expectations. Bubble and crash dynamics is triggered by shocks to fundamentals and amplified by agents switching endogenously between a mean-reverting fundamental rule and a trend-following rule, based upon their relative performance. We also discuss learning-to-forecast laboratory experiments, showing
that in positive feedback systems individuals coordinate expectations on non-rational, almost self-fulfilling equilibria with persistent price fluctuations very
different from rational equilibria. Economic policy analysis may benefit enormously by focussing on efficiency and welfare gains in correcting mispricing of almost self-fulfilling equilibria.