Model reference adaptive expectations in Markov-switching economies

Abstract

This paper offers a theory of model reference adaptive beliefs as a selection device in Markov-switching economies under equilibrium indeterminacy. Consistent with the classical rational choice paradigm, our theory requires that endogenous expectations be replaced with a general-measurable function of the observable states of the model, to be determined optimally. This forecasting function is derived as the regime-independent feedback control minimizing the mean-square deviation of the equilibrium path from the corresponding perfect-foresight state motion (the reference model). We show that model reference adaptive expectations always generate a rational expectations equilibrium, irrespective of the presence of nonlinearities and/or imperfect information. Under equilibrium indeterminacy, this forecasting mechanism enforces the unique mean-square stable solution producing nearly perfect-foresight dynamics