Rational vs. irrational beliefs in a complex world

Open Access
Authors
Publication date 04-2025
Journal Journal of Economic Behavior and Organization
Article number 106898
Volume | Issue number 232
Number of pages 18
Organisations
  • Faculty of Economics and Business (FEB) - Amsterdam School of Economics Research Institute (ASE-RI)
Abstract

How do rational and boundedly rational agents interact in a competitive asset market? To answer this question, we build a highly nonlinear asset pricing model where agents hold heterogeneous beliefs. Our model features fully rational forward looking agents versus boundedly rational backward looking agents whose market shares evolve endogenously. This gives rise to chaotic model dynamics which are characterized by complex bubble and crash dynamics, even without any exogenous fluctuations. We show that computational methods can be applied to numerically analyze models combining agents forming rational expectations and agents forming extrapolative expectations, with the possibility of transition between one type of behavior and the other. Not only do we find that boundedly rational agents remain in the market, but document that their effect on price dynamics is even amplified by the behavior of fully rational agents. In their interaction, trend-extrapolators amplify small deviations from fundamentals, while rational agents eventually anticipate market crashes after large bubbles and drive prices back to the fundamental.

Document type Article
Language English
Published at https://doi.org/10.1016/j.jebo.2025.106898
Other links https://www.scopus.com/pages/publications/85218266772
Downloads
1-s2.0-S0167268125000186-main (Final published version)
Permalink to this page
Back