How does bounded rationality impact the formation of expectations in economic models?

Bounded rationality refers to the idea that individuals have limited cognitive abilities and information processing capabilities, which leads them to make decisions that are not fully rational or optimal. In the context of economic models, bounded rationality has a significant impact on the formation of expectations.

Firstly, bounded rationality affects how individuals gather and process information to form their expectations. Due to cognitive limitations, individuals cannot consider all available information or analyze it in a fully rational manner. Instead, they rely on heuristics, rules of thumb, and simplified mental models to make sense of complex economic situations. This can lead to biases and errors in their expectations.

For example, individuals may rely heavily on recent or vivid information, leading to the availability bias. This bias can result in expectations that are overly influenced by recent events, such as a recent economic boom or recession, without considering the underlying factors that may affect future outcomes.

Secondly, bounded rationality affects how individuals update their expectations over time. Economic models often assume that individuals have perfect foresight and can accurately predict future outcomes based on all available information. However, bounded rationality suggests that individuals may struggle to update their expectations in a fully rational manner.

Individuals may exhibit anchoring bias, where they anchor their expectations to a reference point or initial information and adjust insufficiently from that point. This can result in sticky expectations, where individuals fail to update their beliefs in response to new information or changes in economic conditions.

Furthermore, bounded rationality can lead to herding behavior, where individuals imitate the actions and expectations of others instead of independently forming their own expectations. This can result in the formation of expectations that are based on social influence rather than a careful analysis of economic fundamentals.

Overall, bounded rationality has a profound impact on the formation of expectations in economic models. It highlights the limitations of human cognition and decision-making, leading to biases, errors, and deviations from fully rational expectations. Recognizing and incorporating bounded rationality into economic models is crucial for a more realistic understanding of how expectations are formed and how they influence economic outcomes.