Ecomony

This is a chapter in a new series of Handbook in Financial Economics entitled “ Dynamics and Evolution of Financial Markets.” It explores works which contribute to explaining market dynamics and volatility by employing models of rational but diverse beliefs. This excludes models of Behavioral Economics. The first part gives a complete exposition of Noisy Rational Expectations (i.e. REE) Asset Pricing Theory where diversity of beliefs arises from diverse private information. Examination of these models enable us to evaluate the assumptions made and the ability of the models to explain the data about market dynamics. The general conclusion is that, although Noisy REE asset pricing theories have many attractive features, they do not offer a satisfactory paradigm for market dynamics. Indeed, for most models increased amount of idiosyncratic private information leads to a reduction in volatility.

We next turn to models of diverse beliefs without private information. We explore work on Rational Belief Equilibria (i.e. RBE) starting with modeling beliefs. Agents do not know the structure of the dynamically complex economy but have data over a long time to enable an econometric computation of the empirical moments, on the basis of which they compute a commonly known empirical probability on sequences. A belief is then a model of deviations from the empirical probability. It is shown that to be rational a belief cannot be constant, creating an