Working Paper

Reflexivity, expectations feedback and almost self-fulfilling equilibria: economic theory, empirical evidence and laboratory experiments

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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 focusing on efficiency and welfare gains in correcting mispricing along almost self-fulfilling equilibria.