The Pareto domination of irrational expectations over rational expectations (Q1113786)

A simple overlapping generations economy, à la Samuelsen, with one consumer in every generation and with one consumption good in every period, and a fixed stock of outside money, is considered. It is shown that a sequence of temporary economic equilibria which emerges when economic agents predict future prices using an ``irrational'' inelastic expectation function always generates an allocation of consumption across generations which Pareto dominates the corresponding allocation generated by the rational expectation function. Furthermore, it is shown that in spite of systematic prediction errors, the inelastic expectation function generates an allocation which is efficient.