Publication Title
Economic Modelling
Document Type
Article
Department or Program
Economics
Publication Date
9-1-2015
Keywords
Adaptive Learning, Bounded rationality, Forecasting, Underparameterization
Abstract
I develop a framework where agents forecast despite knowing only a subset of the variables in the true economic model. I then examine whether the discovery of an additional variable improves forecasting. Because agents do not know all of the variables in the model, they form expectations using bounded rationality. Under adaptive learning, agents form expectations by regressing a variable of interest on the revealed variables. Surprisingly, I find that the revelation of an additional variable often worsens forecasts, an event deemed a red herring, with probability greater than one-half. If the model includes endogenous variables that depend on agents' expectations, then revealing a new variable will occasionally lead to a catastrophic worsening of forecast accuracy. Under structural coefficients expectations, agents know how each revealed variable appears in the true model and they use this information to forecast. Now, the revelation of a new variable improves forecasting more often than not. I then apply the framework to a calibrated New Keynesian model and find that the revelation of a new variable usually worsens forecasting. Collectively, these results show that learning about a new variable may actually make forecasts less accurate.
Recommended Citation
Shea, P. 2015. "Red herrings and revelations: Does learning about a new variable worsen forecasts?" Economic Modelling. 49: 395-406. https://doi.org/10.1016/j.econmod.2015.05.012
Creative Commons License
This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 License.
Copyright Note
This is the author's version of the work. This publication appears in Bates College's institutional repository by permission of the copyright owner for personal use, not for redistribution.
Required Publisher's Statement
Original version is available from the publisher at: https://doi.org/10.1016/j.econmod.2015.05.012