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Did the US consumer overreact? A test of rational expectations

  • L’Huillier, Jean-Paul

Using data for the US economy from 1995 to 2008, I estimate a business cycle model in which consumers form expectations rationally, and an alternative model that explicitly allows for deviations from rational expectations in the form of overreaction to noisy signals. The second model does not have any advantage in explaining the movements in consumption and productivity in this period. Therefore, I cannot reject the hypothesis that consumers behaved rationally. The rather exuberant movements of this episode are rationalized by a story in which permanent income consumers find it hard to distinguish between permanent movements in productivity and temporary ones. Consumers who update their beliefs about trends in productivity on the basis of fairly noisy signals adjust their behavior very slowly. After the 1995–2000 productivity boom, consumers learnt very slowly about a subsequent decline in productivity growth, which led to financial and trade imbalances that ended in a correction starting around 2007. The whole boom-bust cycle was long, taking about 14 years to complete.

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Article provided by Elsevier in its journal Economics Letters.

Volume (Year): 116 (2012)
Issue (Month): 2 ()
Pages: 207-209

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Handle: RePEc:eee:ecolet:v:116:y:2012:i:2:p:207-209
Contact details of provider: Web page: http://www.elsevier.com/locate/ecolet

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  1. Lubos Pastor & Pietro Veronesi, 2005. "Technological Revolutions and Stock Prices," NBER Working Papers 11876, National Bureau of Economic Research, Inc.
  2. Summers, Lawrence H, 1986. " Does the Stock Market Rationally Reflect Fundamental Values?," Journal of Finance, American Finance Association, vol. 41(3), pages 591-601, July.
  3. Boyan Jovanovic & Jeremy Greenwood, 1999. "The Information-Technology Revolution and the Stock Market," American Economic Review, American Economic Association, vol. 89(2), pages 116-122, May.
  4. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
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