Expectations in an OG Economy

Dynamic economic models usually describe the path of economic variables as prices, consumption or capital at equilibrium. The most popular models assume that agents have perfect foresight. Implicitly this assumption requires that agents can compute the complete infinite path, an exercise that requires to solve a system of equations involving an infinite num- ber of equations and unknowns. Equivalently, one could assume that there is a well behaved and fast mechanism driving the economy to the temporary equilibrium. A major difficulty is that the behavior of the consumers in any given period depends on the present and all the fu- ture prices. In the paper, we consider an overlapping generation model in which the consumers form expectations using truncated versions of the model. The mechanism of price adjustment may then be analyzed. Both the expectational dynamics, as treated in Balasko (1994), and the Wal- ras’s tatonnement, as in Hens (1997), are considered. Sufficient conditions for stability of the perfect foresight equilibrium within these price forma- tion mechanisms are derived. We also discuss the issue of the robustness of the results to parameters used in the truncation.