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School of Economics and Finance Seminar Imperfect Information and Hidden Dynamics

Speaker: Professor Paul Levine, University of Surrey

Abstract: In a DSGE rational expectations model, the nature of agents' information sets is crucial for both the dynamics of the solution and for whether an econometrician can infer structural shocks and impulse responses from such a DGP. In incomplete markets, heterogeneous agent framework, we exploit results on single-agent signal extraction problems to show that, with extreme heterogeneity, the aggregate solution to the individual agent's informational problem is a transformation of a representative agent's problem with imperfect information (II). When under II, agents cannot infer the shocks (‘non-A-invertibility'); a) the rational expectations solution for the aggregate economy incorporates Blaschke factors and has a higher state dimension than under perfect information (PI); b) in contrast, the ‘innovations representation' for an econometrician with the same II information set has the same state dimension as under PI – hence the shocks are neither invertible nor recoverable, but c) a measure of ‘approximate invertibility' can mitigate the problem for some structural shocks.

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