Kevin X.D. Huang, Zheng Liu, and Tao Zha
Working Paper 2008-20
September 2008

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This study explores the macroeconomic implications of adaptive expectations in a standard real business cycle model. When rational expectations are replaced by adaptive expectations, we show that the self-confirming equilibrium is the same as the steady-state rational expectations equilibrium for all admissible parameters but that dynamics around the steady state are substantially different between the two equilibria. The differences are driven mainly by the dampened wealth effect and the strengthened intertemporal substitution effect, not by the escapes emphasized by Williams (2003). As a result, adaptive expectations can be an important source of frictions that amplify and propagate technology shocks and seem promising for generating plausible labor market dynamics.

JEL classification: E32

Key words: self-confirming equilibrium, amplification, labor market dynamics, wealth and substitution effects, hump-shaped responses

The authors thank the referees and the editor as well as Klaus Adam, James Bullard, Marty Eichenbaum, Martin Ellison, George Evans, Seppo Honkapohja, Selo Imrohoroglu, Bruce Preston, Tom Sargent, and Paolo Surico for helpful comments. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Kevin X.D. Huang, Department of Economics, Vanderbilt University, VU Station B #351819, 2301 Vanderbilt Place, Nashville, TN 37235-1819, 615-936-7271,; Zheng Liu, Research Department, Federal Reserve Bank of San Francisco, 101 Market Street, San Francisco, CA 94105, 415-974-3328,; or Tao Zha, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8353,

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.