Price formation under uncertainty

Du Preez, Johan

Price formation under uncertainty

Master Thesis

2003

Publisher

University of Cape Town

Department

School of Economics

Faculty

Faculty of Commerce

Abstract

The analysis presented in this thesis is aimed at better understanding the role of expectations to the price formation process. Since general competitive analysis lacks a coherent explanation of how expectations are formulated it is difficult to promote theories that assume agents have no structural knowledge in favour of theories that assume agents have significant structural knowledge, e.g. rational expectations hypothesis versus the theory of rational beliefs. Accordingly, empirical evidence is presented to support analyses of models in which agents are not assumed to have structural knowledge. Simple general equilibrium models are used to illustrate that modelling risk requires a thorough analysis of investor expectations embedded in asset prices to better understand the information conveyed by observed risk premia. Analysis of the role of diverse expectations in competitive equilibria shows that a prerequisite for the existence of a short-run Walrasian monetary equilibrium is the existence of at least one agent whose expectations are insensitive to current prices. Ergodic theory shows that any stable dynamical system generates a stationary probability measure based on its underlying generating probability that is unrelated to the data generated by the dynamical system. This result is used to show that the conditions under which diverse beliefs arise are sufficiently general to warrant the study of the impact of diverse expectations on the price formation process. Enthusiasm for models that allow diverse beliefs is however tempered by a review of Sunspot theory that show that it is not necessary to abandon the rational expectations hypothesis in order for competitive markets to be subject to speculative fluctuations that are driven by expectations. This analysis is reinforced by a known example that shows that adaptive learning rules can lead rational agents to believe in nonstationary, indeterminate equilibria that are locally stable, such as Sunspot Equilibria. This leads to an important conclusion; diverse beliefs are not temporary phenomena since disequilibrium-learning analysis cannot be relied on to teach investors the economy's equilibrium map.

Description

Bibliography: leaves 170-173.

Keywords

Economics

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