On endogenous formation of price expectations
Abstract
We study a two-period exchange economy with complete financial markets and endogenous borrowing constraints. Contrary to perfect foresight paradigm, we assume that agents are heterogeneous in their ability to forecast future prices. We introduce a new equilibrium concept, called informationally constrained equilibrium, where the formation of price expectations is endogenous and reflects the revelation of information from observing bounds on liabilities designed to ensure solvency at any contingency. We prove that, under standard assumptions, an equilibrium always exists and we characterize the degree of information revealed by the endogenous debt limits.