Misperception-driven chaos: Theory and policy implications

In a large economy, it is extremely difficult, if not impossible, to immediately grasp the state of our surrounding environment with precision since we normally have access only to a subset of relevant information. In this paper, we introduce this information imperfection into an ordinary model of endogenous business cycles and examine how it would affect the dynamic nature of the model. We, in particular, present a mechanism by which observation errors result in chaotic fluctuations in a model that would behave regularly otherwise, thereby indicating the importance of potential misperception about the current state in a qualitative sense. Also, our model is tractable enough to explicitly derive a policy index of chaotic fluctuations under some conditions. This feature of the model allows us to draw some policy implications regarding the observability of macroeconomic state variables.