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Evans, George W.
Hommes, Cars H.
McGough, Bruce
Salle, Isabelle
Year of Publication: 
Series/Report no.: 
Bank of Canada Staff Working Paper 2019-27
We consider boundedly rational agents who do not plan over the infinite future but make trading plans at a finite, arbitrary horizon. We investigate the role of that horizon in the price dynamics of an asset in a Lucas tree model. We then design a laboratory experiment to test our theoretical predictions against the behaviors of human subjects. Short-horizon markets are prone to substantial and prolonged deviations from rational expectations (RE). By contrast, markets populated by even a modest share of long-horizon forecasters exhibit convergence towards the fundamental price. Longer-horizon forecasts do display more heterogeneity and thus some departure from RE; however this same heterogeneity also prevents the coordination of subjects on wrong anchors - a pattern of behavior that leads to mispricing in short-horizon markets. Long-horizon forecasts are well-described by adaptive learning, which delivers convergence to RE equilibrium, while short-horizon forecasts exhibit destabilizing trend-chasing.
Asset pricing
Central bank research
Economic models and financial markets
Document Type: 
Working Paper

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