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Natural Expectations and Macroeconomic Fluctuations

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  • Andreas Fuster
  • David Laibson
  • Brock Mendel

Abstract

A large body of empirical evidence suggests that beliefs systematically deviate from perfect rationality. Much of the evidence implies that economic agents tend to form forecasts that are excessively influenced by recent changes. We present a parsimonious quasi-rational model that we call natural expectations, which falls between rational expectations and (na�ve) intuitive expectations. (Intuitive expectations are formed by running growth regressions with a limited number of right-hand-side variables, and this leads to excessively extrapolative beliefs in certain classes of environments). Natural expectations overstate the long-run persistence of economic shocks. In other words, agents with natural expectations turn out to form beliefs that don't sufficiently account for the fact that good times (or bad times) won't last forever. We embed natural expectations in a simple dynamic macroeconomic model and compare the simulated properties of the model to the available empirical evidence. The model's predictions match many patterns observed in macroeconomic and financial time series, such as high volatility of asset prices, predictable up-and-down cycles in equity returns, and a negative relationship between current consumption growth and future equity returns.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.24.4.67
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Bibliographic Info

Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 24 (2010)
Issue (Month): 4 (Fall)
Pages: 67-84

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Handle: RePEc:aea:jecper:v:24:y:2010:i:4:p:67-84

Note: DOI: 10.1257/jep.24.4.67
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  1. LeBaron, Blake & Arthur, W. Brian & Palmer, Richard, 1999. "Time series properties of an artificial stock market," Journal of Economic Dynamics and Control, Elsevier, vol. 23(9-10), pages 1487-1516, September.
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  7. Shlomo Benartzi, 2001. "Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock," Journal of Finance, American Finance Association, vol. 56(5), pages 1747-1764, October.
  8. Laurence Ball, 2000. "Near-Rationality and Inflation in Two Monetary Regimes," NBER Working Papers 7988, National Bureau of Economic Research, Inc.
  9. De Long, J Bradford, et al, 1990. " Positive Feedback Investment Strategies and Destabilizing Rational Speculation," Journal of Finance, American Finance Association, vol. 45(2), pages 379-95, June.
  10. Harrison Hong & Jeremy C. Stein, 2003. "Simple Forecasts and Paradigm Shifts," Harvard Institute of Economic Research Working Papers 2007, Harvard - Institute of Economic Research.
  11. Eugene F. Fama, . "Market Efficiency, Long-term Returns, and Behavioral Finance," CRSP working papers 340, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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