Intrinsic heterogeneity in expectation formation

We introduce the concept of Misspecification Equilibrium to dynamic macroeconomics. Agents choose between a list of misspecified econometric models and base their selection on relative forecast performance. A Misspecification Equilibrium is a stochastic process in which agents forecast optimally given their choices, with forecast model parameters and predictor proportions endogenously determined. Under appropriate conditions, the Misspecification Equilibrium will exhibit Intrinsic Heterogeneity, in which all predictors are used at all times, even in the neoclassical limit in which only the most successful predictors are used. This equilibrium is attainable under least-squares learning and dynamic predictor selection based on average profits. (c) 2005 Elsevier Inc. All rights reserved.