LEARNING TO BELIEVE IN NONRATIONAL EXPECTATIONS THAT SUPPORT PARETO-SUPERIOR OUTCOMES

I consider the prototype New Keynesian macroeconomic model with subjec tive demand expectations of firms. In this model the firms' objective demand is log-linear in their relative price. Firms believe that their demand curve is linear or log-linear in their absolute price. They es timate the parameters of this curve by least squares from past observa tions on prices and quantities. The wage rate either clears the labor market given firms' demand perceptions or is given in the short run an d changes according to a linear Phillips curve. In either setup of the model the interplay between learning and price setting confirms the s ubjective model. Among the long-run equilibria are solutions at which the representative household attains a higher level of utility as comp ared to the rational-expectations outcome. If the supply of labor depe nds upon the real wage, money is not neutral.