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Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

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  • Fuster, Andreas
  • Herbert, Benjamin
  • Laibson, David I.

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

Paper provided by Harvard University Department of Economics in its series Scholarly Articles with number 10140029.

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Date of creation: 2011
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Publication status: Published in NBER Macroeconomics Annual
Handle: RePEc:hrv:faseco:10140029

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Cited by:
  1. Vasileios Barmpoutis, 2014. "The Naive Extrapolation Hypothesis and the Rosy-Gloomy Forecasts," Papers 1406.1733, arXiv.org.
  2. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper, Norges Bank 2013/05, Norges Bank.
  3. Patrick A. Pintus & Jacek Suda, 2014. "Learning Financial Shocks and the Great Recession," Working Papers halshs-00830480, HAL.
  4. Michael Woodford, 2013. "Macroeconomic Analysis without the Rational Expectations Hypothesis," NBER Working Papers 19368, National Bureau of Economic Research, Inc.
  5. Marlène Isore, 2012. "Essays in macro-finance," Sciences Po publications info:hdl:2441/eo6779thqgm, Sciences Po.
  6. 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.
  7. Danny Yagan, 2014. "Riding the Bubble? Chasing Returns into Illiquid Assets," NBER Working Papers 20360, National Bureau of Economic Research, Inc.
  8. Jeff Fuhrer, 2012. "Real expectations: replacing rational expectations with survey expectations in dynamic macro models," Working Papers, Federal Reserve Bank of Boston 12-19, Federal Reserve Bank of Boston.
  9. Eleonora Granziera & Sharon Kozocki, 2012. "House Price Dynamics: Fundamentals and Expectations," Working Papers, Bank of Canada 12-12, Bank of Canada.
  10. Daniel L. Tortorice, 2014. "Equity Return Predictability, Time Varying Volatility and Learning About the Permanence of Shocks," Working Papers, Brandeis University, Department of Economics and International Businesss School 70, Brandeis University, Department of Economics and International Businesss School.
  11. repec:dgr:uvatin:2013014 is not listed on IDEAS
  12. Marlène Isoré & Urszula Szczerbowicz, 2013. "Disaster Risk in a New Keynesian Model," Working Papers 2013-12, CEPII research center.

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