Reflexive Expectation Formation

How do economic agents form expectations regarding prices, when there is a fundamental uncertainty about the market process, like in or after financial crises? How does the formation of expectations fold back to the realized economic process, and in particular, to the selection of one of multiple possible equilibria in the economic process? We present a game theoretical model in which these questions can be studied in a systematic way. We argue that financial expectation formation can be usefully studied as a game-like situation of mutual anticipation of economic agents, if the key uncertainties that drive the development are endogenous, that is, if there is uncertainty about the actions of other economic agents. For instance, after the financial crisis of 2008, there was uncertainty about how governments, banks, and firms would behave, and the anticipation of this behavior was key to the formation of financial expectations of individual agents. In our model, individual agents entertain higher order beliefs regarding the expectations of other economic agents, which are the basis for their own expectation formation. These beliefs are updated in a learning process. The learning process is more complex as in REE models: Prices also contain endogenously generated information regarding the mutual expectations of different agents. Agents cannot fully distinguish if price movements are caused by a change in information about fundamentals, or a change in expectations of the other agents.