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Lock-in of extrapolative expectations in an asset pricing model

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  • Kevin J. Lansing

Abstract

This paper examines an agent's choice of forecast method within a standard asset pricing model. To make a conditional forecast, a representative agent may choose one of the following: (1) a rational (or fundamentals-based) forecast that employs knowledge of the stochastic process governing dividends, (2) a constant forecast based on a simple long-run average of the forecast variable, or (3) a time-varying forecast that extrapolates from the last observation of the forecast variable. I show that a representative 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. Under extrapolative expectations, 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. All of these features appear to be present in long-run U.S. stock market data.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory with number 2004-06.

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Date of creation: 2005
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Handle: RePEc:fip:fedfap:2004-06

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Keywords: Stock - Prices ; Forecasting;

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References

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Citations

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Cited by:
  1. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Working Papers 17301, National Bureau of Economic Research, Inc.
  2. Park, Yung Chul & Song, Chi-Young, 2011. "Prospects for Monetary Cooperation in East Asia," ADBI Working Papers 314, Asian Development Bank Institute.
  3. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper 2013/05, Norges Bank.
  4. Kevin J. Lansing, 2007. "Rational and near-rational bubbles without drift," Working Paper Series 2007-10, Federal Reserve Bank of San Francisco.
  5. Kevin J. Lansing, 2006. "Time-Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve," Computing in Economics and Finance 2006 488, Society for Computational Economics.
  6. Kevin J. Lansing, 2007. "Asset price bubbles," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue Oct 26.
  7. 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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