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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 Paper Series with number 2004-06.

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Date of creation: 2005
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Handle: RePEc:fip:fedfwp: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. 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. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Working Papers 17301, National Bureau of Economic Research, Inc.
  3. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper Series 2013-03, Federal Reserve Bank of San Francisco.
  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, 2007. "Asset price bubbles," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct26.
  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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