Expectation Formation and the Persistence of Shocks

Persistence of economic shocks is commonly treated as deviations from rational expectations attributed to frictions like information rigidity or noisy information. This paper shows that there is persistence even without these information frictions. In the presence of uncertainty about the future, optimal forecasts place a positive weight on past predictions about the same event. The overall weight on the past prediction varies markedly over time and has an inverse relationship with the magnitude of shocks as the larger revisions after large shocks reduce the weight. Empirical estimates show that agents put a significant weight on previous prediction of inflation and output and a substantial part of the weight and hence persistence cannot be attributed to information frictions.