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Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

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  • Andreas Fuster
  • Benjamin Hebert
  • David Laibson

Abstract

How does an economy behave if (1) fundamentals are truly hump-shaped, exhibiting momentum in the short run and partial mean reversion in the long run, and (2) agents do not know that fundamentals are hump-shaped and base their beliefs on parsimonious models that they fit to the available data? A class of parsimonious models leads to qualitatively similar biases and generates empirically observed patterns in asset prices and macroeconomic dynamics. First, parsimonious models will robustly pick up the short-term momentum in fundamentals but will generally fail to fully capture the long-run mean reversion. Beliefs will therefore be characterized by endogenous extrapolation bias and pro-cyclical excess optimism. Second, asset prices will be highly volatile and exhibit partial mean reversion—i.e., overreaction. Excess returns will be negatively predicted by lagged excess returns, P/E ratios, and consumption growth. Third, real economic activity will have amplified cycles. For example, consumption growth will be negatively auto-correlated in the medium run. Fourth, the equity premium will be large. Agents will perceive that equities are very risky when in fact long-run equity returns will co-vary only weakly with long-run consumption growth. If agents had rational expectations, the equity premium would be close to zero. Fifth, sophisticated agents—i.e., those who are assumed to know the true model—will hold far more equity than investors who use parsimonious models. Moreover, sophisticated agents will follow a counter-cyclical asset allocation policy. These predicted effects are qualitatively confirmed in U.S. data.

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Bibliographic Info

Article provided by University of Chicago Press in its journal NBER Macroeconomics Annual.

Volume (Year): 26 (2012)
Issue (Month): 1 ()
Pages: 1 - 48

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Handle: RePEc:ucp:macann:doi:10.1086/663989

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Cited by:
  1. Eleonora Granziera & Sharon Kozocki, 2012. "House Price Dynamics: Fundamentals and Expectations," Working Papers 12-12, Bank of Canada.
  2. Vasileios Barmpoutis, 2014. "The Naive Extrapolation Hypothesis and the Rosy-Gloomy Forecasts," Papers 1406.1733, arXiv.org.
  3. Michael Woodford, 2013. "Macroeconomic Analysis without the Rational Expectations Hypothesis," NBER Working Papers 19368, National Bureau of Economic Research, Inc.
  4. Hommes, C.H. & Zhu, M., 2012. "Behavioral Learning Equilibria," CeNDEF Working Papers 12-09, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  5. Marlène Isoré & Urszula Szczerbowicz, 2013. "Disaster Risk in a New Keynesian Model," Working Papers 2013-12, CEPII research center.
  6. Patrick A. Pintus & Jacek Suda, 2013. "Learning Financial Shocks and the Great Recession," AMSE Working Papers 1333, Aix-Marseille School of Economics, Marseille, France, revised 05 Jun 2013.
  7. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper 2013/05, Norges Bank.
  8. Marlène Isore, 2012. "Essays in macro-finance," Sciences Po publications info:hdl:2441/eo6779thqgm, Sciences Po.
  9. Jeff Fuhrer, 2012. "Real expectations: replacing rational expectations with survey expectations in dynamic macro models," Working Papers 12-19, Federal Reserve Bank of Boston.
  10. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.

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