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Expected Versus Realized Income Changes: A Test of the Rational Expectation Hypothesis

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Author Info

  • Das, J.W.M.
  • Soest, A.H.O. van

    (Tilburg University, Center for Economic Research)

Abstract

We analyze answers to household survey questions on whether the respondents' household income has changed in the past twelve months, and on whether the respondents expect their household income to change in the next twelve months. Both questions are answered on a discrete five points scale.The data are an unbalanced panel of eleven consecutive annual waves.Using cross-tabulations of expected and realized changes, we first test the "best-case" hypothesis.This hypothesis implies, under two different nonparametric assumptions on how respondents form their predictions, that respondents have rational expectations, that there are no common unexpected shocks, and that reported expectations are best predictions of future outcomes.We find that the best case hypothesis is rejected: for all years, too many respondents who predict an income fall, ex post report that their household income has not changed.We then construct a bivariate ordered probit random effects panel data model, in which we explain both expectations and realizations from background variables such as age, education level, and labour market status, and from the one year lagged expectation and realization.We show that the hypothesis of rational expectations implies certain restrictions on the parameters in the two equations of this model.The model is estimated by simulated maximum likelihood using the Geweke-Hajivassilou-Keane (GHK) method.The hypothesis of rational expectations is rejected.The hypotheses that expectations are adaptive or naive can be tested in a similar way, and are also rejected.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2000-105.

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Date of creation: 2000
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Handle: RePEc:dgr:kubcen:2000105

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Web page: http://center.uvt.nl

Related research

Keywords: household incomes; rational expectations; panel data; maximum likelihood; JEL classifications;

References

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  1. Das, Marcel & van Soest, Arthur, 1997. "Expected and realized income changes: Evidence from the Dutch socio-economic panel," Journal of Economic Behavior & Organization, Elsevier, vol. 32(1), pages 137-154, January.
  2. Vassilis A. Hajivassiliou & Paul A. Ruud, 1993. "Classical Estimation Methods for LDV Models Using Simulation," Cowles Foundation Discussion Papers 1051, Cowles Foundation for Research in Economics, Yale University.
  3. Das, J.W.M. & Dominitz, J. & Soest, A.H.O. van, 1998. "Comparing predictions and outcomes: theory and application to income changes," Open Access publications from Tilburg University urn:nbn:nl:ui:12-121742, Tilburg University.
  4. Keane, Michael, 1993. "Simulation estimation for panel data models with limited dependent variables," MPRA Paper 53029, University Library of Munich, Germany.
  5. Das, J.W.M. & Soest, A.H.O. van, 1996. "A panel data model for subjective information on household income growth," Open Access publications from Tilburg University urn:nbn:nl:ui:12-121740, Tilburg University.
  6. Alessie, Rob & Lusardi, Annamaria, 1997. "Saving and income smoothing: Evidence from panel data," European Economic Review, Elsevier, vol. 41(7), pages 1251-1279, July.
  7. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1996. "Income Risk, Borrowing Constraints, and Portfolio Choice," American Economic Review, American Economic Association, vol. 86(1), pages 158-72, March.
  8. repec:att:wimass:8905 is not listed on IDEAS
  9. Ivaldi, Marc, 1992. "Survey Evidence on the Rationality of Expectations," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(3), pages 225-41, July-Sept.
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Citations

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Cited by:
  1. Mauro Mastrogiacomo, 2006. "Testing consumers' asymmetric reaction to wealth changes," CPB Discussion Paper 53, CPB Netherlands Bureau for Economic Policy Analysis.
  2. Hugo Benítez-Silva & Debra Dwyer & Wayne-Roy Gayle & Thomas Muench, 2008. "Expectations in micro data: rationality revisited," Empirical Economics, Springer, vol. 34(2), pages 381-416, March.
  3. Hugo Benítez-Silva & Debra S. Dwyer, 2003. "Expectation Formation of Older Married Couples and the Rational Expectations Hypothesis," Working Papers wp062, University of Michigan, Michigan Retirement Research Center.
  4. Xavi Ramos & Christian Schluter, 2003. "Subjective Income Expectations, Canonical Models and Income Risk," Working Papers wpdea0310, Department of Applied Economics at Universitat Autonoma of Barcelona.
  5. Ramos, Xavi & Schluter, Christian, 2006. "Subjective Income Expectations and Income Risk," IZA Discussion Papers 1950, Institute for the Study of Labor (IZA).
  6. R Alessie & A Kapteyn, 2001. "New data for understanding saving," Oxford Review of Economic Policy, Oxford University Press, vol. 17(1), pages 55-69, Spring.

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