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Endogenous vs exogenous fluctuations: unveiling the impact of heterogeneous expectations

Published online by Cambridge University Press:  08 August 2025

Domenico Delli Gatti ,
Filippo Gusella  and
Giorgio Ricchiuti Open the ORCID record for Giorgio Ricchiuti [Opens in a new window]
Domenico Delli Gatti*
Affiliation:
CLE, Università Cattolica del Sacro Cuore, Largo Gemelli 1, Milano, Italy
Filippo Gusella
Affiliation:
CLE, Università Cattolica del Sacro Cuore, Largo Gemelli 1, Milano, Italy Università degli Studi di Firenze, Florence, Italy New York University in Florence, Florence, Italy
Giorgio Ricchiuti
Affiliation:
CLE, Università Cattolica del Sacro Cuore, Largo Gemelli 1, Milano, Italy Università degli Studi di Firenze, Florence, Italy
*
Corresponding author: Domenico Delli Gatti, domenico.delligatti@unicatt.it
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Abstract

This paper investigates the nature of financial market fluctuations by empirically testing three competing models of instability. We contrast a linear state-space model and a nonlinear Markov-switching model – both rooted in heterogeneous behavioral heuristics and capable of generating endogenous dynamics – with a benchmark linear random walk model that assumes exogenous shocks. Using monthly S&P 500 data from 1990 to 2019, we find strong evidence supporting endogenous sources of instability. In particular, models incorporating behavioral nonlinearities significantly outperform both the linear behavioral model and the random walk in short-, medium-, and long-term forecasting. Our findings underscore the importance of accounting for heterogeneous expectations and regime-switching behavior in explaining asset price dynamics.

Keywords

endogenous fluctuationsheterogeneous expectationsstate-space modelsMarkov switching modelsfinancial forecastingC13C51E37G01G10

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Articles
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Macroeconomic Dynamics , Volume 29 , 2025 , e125
Copyright
© The Author(s), 2025. Published by Cambridge University Press

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