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Earnings Misperceptions and Household Distress

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Abstract

Households learn whether income changes are temporary or persistent from the history of their own paychecks. This paper develops a quantitative model of household financial distress that incorporates this inference and uses survey data on income expectations to estimate the extent to which households overweight recent outcomes—diagnostic expectations. The model improves on the standard full-information, rational-expectations benchmark in two key dimensions: it explains financial distress without assuming extreme impatience, and it more accurately captures the empirical correlation between income and interest rates. Learning and diagnostic expectations play a central role, accounting for roughly half of delinquencies and more than one-third of bankruptcies, and generating welfare losses equivalent to a 1.5 percent permanent decline in consumption. Policies designed to reduce financial distress are markedly more effective in the model with diagnostic expectations.

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  • Juan M. Sanchez & Stefan Song, 2025. "Earnings Misperceptions and Household Distress," Working Papers 2025-030, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:101999
    DOI: 10.20955/wp.2025.030
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    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth

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