A dissertation submitted to the doctoral school of economics and management in p

Doctoral Thesis UNIVERSITY OF TRENTO CIFREM INTERDEPARTMENTAL CENTRE FOR RESEARCH TRAINING IN ECONOMICS AND MANAGEMENT DOCTORAL SCHOOL IN ECONOMICS AND MANAGEMENT THREE ESSAYS IN AGENT-BASED MACROECONOMICS A DISSERTATION SUBMITTED TO THE DOCTORAL SCHOOL OF ECONOMICS AND MANAGEMENT IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DOCTORAL DEGREE (PH.) IN ECONOMICS AND MANAGEMENT Giulia Canzian November 2009 ADVISORS DOCTORAL COMMITTEE Dott. Edoardo Gaffeo Prof. Richard Pomfret Università degli Studi di Trento University of Adelaide Prof. Roberto Tamborini Prof.ssa Roberta Raffaelli Università degli Studi di Trento Università degli Studi di Trento Dott.ssa Laura Magazzini Università degli Studi di Verona Prof.

Raffaele Corrado Università degli Studi di Bologna Per chi viaggia in direzione ostinata e contraria Col suo marchio speciale di speciale disperazione E fra il vomito dei respinti muove gli ultimi passi Per consegnare alla morte una goccia di splendore, di umanità, di verità. DeAndrè To Bruno and Celide To my Family Abstract The dissertation is aimed at offering an insight into the agent-based methodology and its possible application to the macroeconomic analysis. Relying on this method- ology, I deal with three different issues concerning heterogeneity of economic agents, bounded rationality and interaction. Specifically, the first chapter is devoted to describe the distinctive characteristics of agent-based economics and its advantages-disadvantages.

In the second chapter I propose a credit market framework characterized by the presence of asymmetric in- formation between the banks and the entrepreneurs. I analyze how entrepreneurs’ heterogeneity and the presence of Relationship Banking influences the macro prop- erties of the designed system. In the third chapter I work to take the core of Keynes’s macroeconomics into the computer laboratory, in the spirit of a counterfactual his- tory of economic thought. In particular, I devote much effort in the behavioural characterization of the three pillars of Keynes’s economics – namely the MEC, MPC and LP – relying on his clear refusal of perfect rationality in the decision making process.

The last chapter adds to the literature that assesses the impact of monetary policy under the hypothesis of agent’s bounded rationality. Indeed, I design a quasi rational process through which inflation expectations are updated, and then I ana- lyze how this hypothesis interacts with the efficacy of different monetary policy re- gimes. Keywords Macroeconomics, Agent-based economics, Complex Adaptive System 6 Contents INTRODUCTION. 1 AN INSIGHT INTO AGENT-BASED ECONOMICS.

WHAT ARE AGENT BASED MODELS?. WHY AGENT BASED MODELS AND NOT DSGE FOR A MODERN MACROECONOMICS?. THE AGENT–BASED NATURE OF THIS DISSERTATION. 17 FIRM-BANK RELATIONSHIP AND THE MACROECONOMY: SOME COMPUTATIONAL EXPERIMENTS.

FINANCE AND THE ECONOMY. AN OVERVIEW ABOUT RELATIONSHIP BANKING .1 Basic framework: the Symmetric Information case. Bank-firm interactions .2 Pure Asymmetric Information treatment .3 Relationship Banking treatment. Pure Asymmetric treatment versus Relationship Banking treatment.

48 KEYNES IN THE COMPUTER LABORATORY.AN AGENT-BASED MODEL WITH MEC, MPC, LP. UNCERTAINTY, ANIMAL SPIRITS AND MARKET SENTIMENT. PROTAGONISTS ON STAGE: MEC, MPC AND LP. The Marginal Efficiency of Capital.

The Marginal Propensity to Consume. The Liquidity Preference. ANIMAL SPIRITS AND MARKET SENTIMENT AFTER KEYNES. AN ABM OF A KEYNESIAN ECONOMY .2 The Marginal Efficiency of Capital.

The Marginal Propensity to Consume. The Liquidity Preference .5 Modelling Market Sentiment. Market Sentiment in motion .3 Implementing the model with Unconditional Market Sentiment .4 Implementing the model with Endogenous Market Sentiment .5 Reproducing under-production and under-investment. 92 INFLATION EXPECTATIONS AND MARKET SENTIMENT: SOME COMPUTATIONAL EXPERIMENTS.

A GENERAL OVERVIEW OF NEO CLASSICAL MONETARY POLICY THEORY. QUESTIONING RATIONAL EXPECTATIONS: THE LEARNING LITERATURE AND DEVELOPMENTS. INFLATION EXPECTATIONS AND MARKET SENTIMENT. The Old Regime versus the Modern regime.2 Flexible money supply rule .3 Changing the importance attached to inflation expectations.

137 CHAPTER 2 – FLOW DIAGRAM. 141 ii iii Introduction Introduction “The economy is an evolving, complex, adaptive dynamic system. Much progress has been made in the study of such systems in a wide variety of fields, such as medicine an brain research, ecology and biology, in recent years. To people from one of these fields who come to take an interest in ours, economists must seem in the grips of an entirely alien and certainly unpromising methodology.

In these other fields, computer modelling and experimentation is accepted without much question as valuable tools. It was possible, already 15 years ago, to hope that economists would find them valuable as well [Leijonhufvud, 1993]. But the inter- vening years have not witnessed a stampede into agent-based economics.” (Leijon- hufvud, 2006, pag.1627) This dissertation is my personal first tentative to work towards what Leijonhufvud called “Agent Based Macroeconomics”. It is a tentative in the sense that the agent based methodology is both in its “technical infancy” (Lejionhufvud, 2006) and it is still considered controversial by the majority of the profession.

Nonetheless, I found particularly inspiring the previously cited Lejionhufvud’s article, and I decided to go deeper into the understanding of how agent-based modelling can help us in disentangling the inner characteristics of complex economic systems. Which are the reasons to consider real economies as complex systems? If I was to put it very briefly, I would highlight three interrelated points. First, real people are heterogeneous. Probably we can bring back their economic behav- iour to some reasonable and homogeneous macro behaviour, but this cannot overcome the fact that they are inherently different.

The inner diversity makes them behave in a variety of manners at the very micro level. Second, people are not unbounded rational. Real economic agents are neither able to per- fectly forecast the future, nor they are able to perform very complex computation, so that it is quite controversial assuming them to choose through the resolution of optimizing processes. In- Introduction deed, bounded rational people are not necessarily irrational, in the sense that most people follow reasonable economic patterns, and most of the times they do not degenerate in some crazy con- duct.

Their bounded rationality can be traced back to the incapability of processing all the infor- mation they would need to take rational economic decisions. Third, the former characteristics imply interaction. People interact because of their het- erogeneity, and therefore because interacting they can overcome their lack of knowledge and their incapability of processing information. Interaction becomes a way through which coping with bounded rationality.

The three features taken together render any economic system complex, adaptive and dy- namic. Indeed, the chapters of this thesis try to assess the study of the economy as a complex system taking as reference point the latter issues. Since traditional DSGE models perform poorly in tackling these problems, I am working in the spirit of Leijonhufuvd’s words, that is, I aim at showing that agent based economics en- dows economists with the possibility of building models that better assess such complex systems. These models then present us with a better understanding of the macroeconomic dynamics result- ing from micro behaviour characterization.

Chapter 1 offers an overview about what agent based models are and why they can be considered good alternatives to general equilibrium optimizing models, highlighting the differ- ences between ABM and assumption-based economics. In particular, they will be presented both the advantages of this new methodology and the disadvantages of it. Finally, I will show why the older Classical Economics can be considered as a precursor of the principles on which agent based economic is built on. The three subsequent chapters deal in different ways with the issues characterizing com- plex economies.

Chapter 2 tries to shed light on the implications of having heterogeneous entrepreneurs in an asymmetric information framework regulated by Relationship Banking. On one hand, the Fi- nancial Fragility literature points at demonstrating that economic fluctuations can be traced back to the presence of asymmetric information in the credit market although neither considering het- erogeneous entrepreneurs, nor differentiating the possible contractual arrangements that regulate bank-firm interactions. On the other hand, both the theoretical and the empirical literature about Relationship Banking do not consider heterogeneous agents and do not study the macroeconomic impact of such credit relationship. Aiming at overcoming these limitations, I build a model in which the economy is populated by entrepreneurs who are heterogeneous both in their productive capacity and in their opportunistic attitude.

In order to produce they have to ask for credit to a 2 Introduction bank, which is not able to distinguish good entrepreneurs ex-ante. Then, I envision two treat- ments. In the first one, the bank faces asymmetric information by charging each entrepreneur with the same interest rate since it is not able to discriminate among them. In the second one, the bank has the possibility of discriminating entrepreneurs ex-post upon their being good long term clients or not: in the former case, the bank charge entrepreneurs with a lower interest rate.

The two situations will be separately analyzed in order to assess which situation is better in terms of aggregate efficiency and macro dynamics. Chapter 3 offers an interpretation of Keynes’s intuitions in the spirit of conducting a counterfactual history of economic thought. In particular, the agent based model deals with one of the most controversial and neglected issues of the General Theory, namely, agents’ bounded rationality in the form of limited information processing. The economy is designed such that all economic decisions are mediated by the Market Sentiment, that is, they are taken not through op- timization processes but through heuristics based on personal feelings and common sense.

The three pillars of the General Theory are modelled in light of this assumption: the Marginal Effi- ciency of Capital, the Marginal Propensity to Consume and the Liquidity Preference change along with the Market Sentiment and in turn impact over the economy. Simulations are con- ducted in order to study whether the framework is able to produce a coherent aggregate dynamics resembling the principal characteristics that Keynes highlighted. Chapter 4 wants to analyze the implications of assuming bounded rational agents for the design of monetary policy. Indeed, the theoretical framework upon which monetary policy has been designed in the last years still results unsatisfactory in considering agents’ bounded rational- ity.

The learning literature has offered some developments with respect to traditional DSGE models, but its principle of cognitive consistency remains controversial; not only, a part from ex- pectations formation, the learning literature assumes the rest of economic decisions to be regu- lated by optimization processes. My contribution goes in the direction of taking seriously into account bounded rationality in the design of a framework over which monetary policies are to be tested. Indeed, I stay with the model developed in the previous chapter, and complement it with the additional hypothesis that agents form inflation expectations basing upon Market Sentiment; therefore, I let the Market Sentiment to be in turn influenced by inflation dynamics. In this way the system envisions a mechanism for the macro regularities to feed back into the micro behav- iour.

3 Introduction References Leijonhufvud A. (2006), “Agent-Based Macro”., Handbook of Computational Economics, vol. 4 Chapter 1 An insight into Agent-Based Economics In the following I will offer a brief and general overview about agent-based economics. In particular, in section 1, I will introduce what an agent-based model is describing its prin- cipal characteristics as a tool through which many different issues in different fields can be tack- led.

The second section is twofold: first I present the principal features and the main drawbacks that have characterized macroeconomics in the last 40 years, and second I will show how it ap- pears natural to use ABM to overcome these inconsistencies. Finally, in the last section, the validity of the complexity approach in using agent-based techniques is reinforced by looking back to Classical economics: it will result how the seed of it was already present in the pioneer works of the British School, and in particular in Keynes’ and Marshall’s way of thinking about economics. What are Agent Based Models?