Knowledge that Transforms

Economics

The authors investigate the structure of preferences and uncertainty that guarantees that prices are fully revealing even though asset markets are incomplete and there are more sources of uncertainty than assets in the economy. A sufficient condition for fully revealing prices is that investors have preferences of the (possibly state-dependent) linear-risk-tolerance class. Finally, the authors discuss how their result allows one to extend certain existing literature on demand aggregation, welfare analysis, and the pricing of contingent claims to the case in which markets are incomplete and investors have asymmetric private information.

The data base compiled during the norming of the Third Edition of the Test of Understanding College Economics (TUCE III) (Saunders, 1994) contains information from 40 instructors of introductory microeconomics courses at 26 different schools who used the posttest score to determine some part of their students' course grade. Of these students, 1,896 answered 30 questions on micro TUCE III both at the beginning (pretest) and the end (posttest) of their one-term course. This paper will use a comparison of the preand posttest responses to each alternative on each question by each student to analyze patterns of persistence and change in choosing correct and incorrect responses.' For each student on each question, there are five possible response patterns:

Carl Bonham and Richard Cohen (1995) are quite correct in noting the errors in our paper (Keane and Runkle, 1990), which were caused by our ignorance of cointegration. We stand chagrined. However, Bonham and Cohen are overstating their case when they claim that Keane and Runkle's results do not support the empirical validity of the rational-expectations hypothesis (p. 289). Bonham and Cohen focus on our tests of price-forecast rationality conditioned on past oil prices and Ml, which they claim are the core of our paper and provide our most stringent tests of rationality. Those particular tests account for only two paragraphs of our 20-page paper-obviously, these tests do not provide the core results of our paper. Rather, the main result of our paper is that individual price forecasts are unbiased and rational, conditioned on the forecaster's own past errors. No previous researchers had ever found even this limited support for the rational-expectations hypothesis. These core results are unaffected by the cointegration issues noted by Bonham and Cohen. Given that caveat, however, note how few of our results are actually overturned by Bonham and Cohen. Although our test statistics for determining whether forecasters properly condition on Ml growth are incorrect, Bonham and Cohen reach the same conclusion that we do: price forecasts conditioned on Ml growth are rational. Bonham and Cohen do reach different conclusions about forecast rationality than we do when they condition on oil price changes. But they themselves show that forecasters were only irrational in conditioning on oil prices after 1973 (their table 2, rows 5 and 6). To call such forecasting failure irrationality may or may not be correct. We think that Bonham and Cohen's results merely confirm the widespread view that forecasters did not completely understand the effects that oil price shocks would have on the economy because such large oil price shocks had never been seen before. Although Bonham and Cohen overturn only one of our original tests, they do provide additional evidence against forecast rationality with their tests that condition on interest-rate spreads and the unemployment rate. We have no doubt that a search over a large number of conditioning variables will uncover some instances in which forecast rationality is rejected. But conducting such a search will also incorrectly bias tests toward rejecting rationality. Since our original paper, we have also examined the rationality of earnings forecasts made by individual stock analysts-a group that has even more incentive than economic forecasters to make accurate predictions. Although all previous studies in that literature had found individual earnings forecasts to be irrational, we found (Keane and Runkle, 1994) that analysts' forecasts are rational. This additional research provides further support for the paper criticized by Bonham and Cohen.

This note characterizes the nature of Ricardian-equivalence failure when either the old generation's or the young generation's income is uncertain and the nonnegativity constraint on bequests is binding in some states of nature. Assuming a positive third derivative of the utility function, the same condition needed for precautionary savings,' it is shown that the degree of failure of Ricardian equivalence is greater when the corner has to do with parental poverty than when the corner has to do with children's wealth. The reason is that in corners associated with parental poverty (and therefore lower parental consumption) marginal utility is more sensitive to extra consumption, leading to a higher marginal propensity to consume in the first period. Consequently, government transfers cause a substantial reduction of precautionary savings in poor corners, in contrast to rich corners, where precautionary savings are only slightly affected.

This paper explores some aspects of the exchange process that should be of interest to economists who use search theory, and especially to those who use search as a foundation for monetary economics. We are mainly concerned with a question that seems basic but has not been analyzed previously: is there some way to determine endogenously which agents are willing to invest resources in the process of active search for trading partners, and which agents prefer to wait passively for trading partners to come to them? In particular, given a group of buyers with money and a group of sellers with goods, is there any reason to expect that buyers will search for sellers, rather than the other way around? One obvious factor is the relative cost of transporting goods and money; but we are interested in examining whether there is anything about the process of monetary exchange per se, and not merely exogenous search costs, that makes buyers more willing than sellers to bear the costs of seeking out trading partners. We investigate this within a generalized version of the search-theoretic model of fiat money in Kiyotaki and Wright (1991, 1993). We find that there may exist equilibria in which buyers search while sellers do not, even if the search cost is greater for the former. However, there can also exist other equilibria with different properties. Perhaps the key finding is that the situation is not symmetric: factors that determine whether to search are fundamentally different for buyers and sellers. One property of an equilibrium in which only buyers search is that money appears on one side of every transaction, because if sellers do not search they do not meet and cannot barter. This is consistent Robert W. Clower's (1967) observation that money buys goods and goods buy money, but goods do not buy goods, although here it is derived endogenously rather than assumed. Some search-based monetary models simply rule out barter, including Peter A. Diamond (1984), Douglas M. Gale (1986), Diamond and Joel Yellin (1990), Alessandra Casella and Johnathon S. Feinstein (1990), Kiminori Matsuyama et al. (1993), Victor E. Li (1995), and Alberto Trejos and Wright (1995). It is difficult to motivate this absence of barter in these papers. In a model that is similar to the one used here, except search is costless, S. Rao Aiyagari and Neil Wallace (1992) prove that all equilibria involve some barter. A contribution of this paper is to show that barter may disappear once the decision to search is endogenized.