The straw that breaks the camel's back: inferential expectations and sudden belief changes

Abstract

We propose a theory of abrupt shifts in beliefs—termed inferential expectations (IE)—to explain significant structural changes observed in economies. According to this theory, agents conduct hypothesis tests on economic fundamentals, holding firmly to their initial beliefs until the weight of contrarian evidence reaches a critical threshold, prompting a sudden and seemingly disproportionate revision of expectations. We explain the intuition behind this theory, refer to its microfoundations, and list examples of possible applications. We also simulate a simple 3-equation macro model to provide qualitative insight into the recent inflation surge and the policy dilemma it presents. Show more