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Lock-In Of Extrapolative Expectations In An Asset Pricing Model

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  • LANSING, KEVIN J.

Abstract

This paper examines an agent's choice of forecast method within a standard asset pricing model. A representative agent may choose: (1) a fundamentals-based forecast that employs knowledge of the dividend process, (2) a constant forecast that is based on a simple long-run average, or (3) a time-varying forecast that extrapolates from the last observation. I show that an 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. 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.

Suggested Citation

  • Lansing, Kevin J., 2006. "Lock-In Of Extrapolative Expectations In An Asset Pricing Model," Macroeconomic Dynamics, Cambridge University Press, vol. 10(3), pages 317-348, June.
    • Handle: RePEc:cup:macdyn:v:10:y:2006:i:03:p:317-348_05
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    Cited by:

    1. Gelain, Paolo & Lansing, Kevin J., 2014. "House prices, expectations, and time-varying fundamentals," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 3-25.
    2. Lansing, Kevin J. & LeRoy, Stephen F. & Ma, Jun, 2022. "Examining the sources of excess return predictability: Stochastic volatility or market inefficiency?," Journal of Economic Behavior & Organization, Elsevier, vol. 197(C), pages 50-72.
    3. Daniel Heymann & Paulo Daniel Pascuini, 2018. "On The (In)Consistency of Re Modeling," Documentos de trabajo del Instituto Interdisciplinario de Economía Política IIEP (UBA-CONICET) 2018-28, Universidad de Buenos Aires, Facultad de Ciencias Económicas, Instituto Interdisciplinario de Economía Política IIEP (UBA-CONICET).
    4. KevinJ. Lansing, 2010. "Rational and Near-Rational Bubbles Without Drift," Economic Journal, Royal Economic Society, vol. 120(549), pages 1149-1174, December.
    5. Kevin Lansing, 2009. "Time Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(2), pages 304-326, April.
    6. Hirshleifer, David & Li, Jun & Yu, Jianfeng, 2015. "Asset pricing in production economies with extrapolative expectations," Journal of Monetary Economics, Elsevier, vol. 76(C), pages 87-106.
    7. Katsuhiro Oshima, 2017. "Search-for-Yield and Business Cycles," KIER Working Papers 962, Kyoto University, Institute of Economic Research.
    8. Emilian DOBRESCU, 2020. "Self-fulfillment degree of economic expectations within an integrated space: The European Union case study," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(4), pages 5-32, December.
    9. Kedar-Levy, Haim, 2020. "Price discovery in the small and in the large: Momentum and reversal, bubbles, and crashes," Journal of Financial Markets, Elsevier, vol. 48(C).
    10. Yung Chul Park & Chi-Young Song, 2011. "Prospects for Monetary Cooperation in East Asia," ADBI Working Papers 314, Asian Development Bank Institute.
    11. Lansing, Kevin J., 2024. "Replicating business cycles and asset returns with sentiment and low risk aversion," Journal of Economic Dynamics and Control, Elsevier, vol. 167(C).
    12. Kevin J. Lansing, 2007. "Asset price bubbles," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct26.
    13. Andreas Fuster & Benjamin Hebert & David Laibson, 2012. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Macroeconomics Annual, University of Chicago Press, vol. 26(1), pages 1-48.
    14. Oshima, Katsuhiro, 2020. "Search for yield and business cycles," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).
    15. KhasadYahu ZarBabal & Jocelyn Evans, 2018. "Does wall street affect main street? examining potential spillovers from investor stock market sentiment to personal consumption expenditures," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 42(2), pages 293-314, April.
    16. Kevin J. Lansing, 2008. "Speculative growth and overreaction to technology shocks," Working Paper Series 2008-08, Federal Reserve Bank of San Francisco.
    17. Granziera, Eleonora & Kozicki, Sharon, 2015. "House price dynamics: Fundamentals and expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 60(C), pages 152-165.

    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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