This paper studies the stability of competitive equilibria in a model of aggregate employment when the representative agent uses a least-squares forecasting procedure. It is shown that the Pareto inferior low employment steady state is always unstable under least-squares learning, even if it is stable under perfect foresight. The high employment steady state is stable under learning if and only if it is saddle point stable under perfect foresight. This weakens multiple equilibrium theories of coordination failure that purport to explain persistently high unemployment. The Pareto superior high employment steady state will be the focal point of individual forecasting.

This paper presents a model that provides an explanation, based on regime switching in the real interest rate and learning, of why tests based on stock-adjustment models, Euler equations, or decision rules—which emphasize short-run fluctuations in inventories and the interest rate—are unlikely to uncover a negative relationship between inventories and the real interest rate. The model, however, predicts that inventories will respond to long-run movements, that is, to regime shifts in the real interest rate. Tests emphasizing cointegration techniques confirm this prediction and show a significant long-run relationship between inventories and the real interest rate.