Advance Information and Distorted Beliefs in Macroeconomic and Financial Fluctuations

Fluctuations in the beliefs of economic agents can be driven by current fundamentals, advance information about future fundamentals, or distortions resulting from informational or psychological limitations. This paper presents a dynamic stochastic general equilibrium (DSGE) model that jointly considers all three possibilities and estimates their relative importance for explaining macroeconomic and financial data. To discipline the estimation, direct data on subjective forecasts is included in the set of observable variables. Results indicate that both advance information and distorted beliefs are important. On average about two-thirds of the fluctuations in endogenous variables can be attributed to these two sources. While they are equally important for output and employment, advance information is most important for explaining inflation and investment, and distorted beliefs are most important for explaining stock returns and consumption.