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Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

In: NBER Macroeconomics Annual 2011, Volume 26

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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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This chapter was published in:

  • Daron Acemoglu & Michael Woodford, 2012. "NBER Macroeconomics Annual 2011, Volume 26," NBER Books, National Bureau of Economic Research, Inc, number acem11-1, October.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 12404.

    Handle: RePEc:nbr:nberch:12404

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    Cited by:
    1. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper 2013/05, Norges Bank.
    2. Eleonora Granziera & Sharon Kozocki, 2012. "House Price Dynamics: Fundamentals and Expectations," Working Papers 12-12, Bank of Canada.
    3. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.
    4. Jeff Fuhrer, 2012. "Real expectations: replacing rational expectations with survey expectations in dynamic macro models," Working Papers 12-19, Federal Reserve Bank of Boston.

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