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Lock-In Of Extrapolative Expectations In An Asset Pricing Model

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  • LANSING, KEVIN J.

Abstract

This paper examines an agent s choice of forecast method within a standard asset pricing model. A representative agent may choose: (1) a fundamentals-based forecast that employs knowledge of the dividend process, (2) a constant forecast that is based on a simple long-run average, or (3) a time-varying forecast that extrapolates from the last observation. I show that an agent who is concerned about minimizing forecast errors may inadvertently become locked-in to an extrapolative forecast. In particular, the initial use of extrapolation alters the law of motion of the forecast variable so that the agent perceives no accuracy gain from switching to one of the alternative forecast methods. The model can generate excess volatility of stock prices, time-varying volatility of returns, long-horizon predictability of returns, bubbles driven by optimism about the future, and sharp downward movements in stock prices that resemble market crashes.

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Bibliographic Info

Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 10 (2006)
Issue (Month): 03 (June)
Pages: 317-348

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Handle: RePEc:cup:macdyn:v:10:y:2006:i:03:p:317-348_05

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Citations

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Cited by:
  1. Kevin J. Lansing, 2006. "Time-Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve," 2006 Meeting Papers 758, Society for Economic Dynamics.
  2. Kevin J. Lansing, 2007. "Asset price bubbles," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct26.
  3. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 1-48 National Bureau of Economic Research, Inc.
  4. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper Series 2013-03, Federal Reserve Bank of San Francisco.
  5. KevinJ. Lansing, 2010. "Rational and Near-Rational Bubbles Without Drift," Economic Journal, Royal Economic Society, vol. 120(549), pages 1149-1174, December.
  6. Kevin J. Lansing, 2008. "Speculative growth and overreaction to technology shocks," Working Paper Series 2008-08, Federal Reserve Bank of San Francisco.

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