Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

By Andreas Fuster, Benjamin Hébert, David Laibson. NBER macroeconomics annual, 2012

143 citations recorded by the source corpus.

How does an economy behave if (1) fundamentals are truly hump-shaped, exhibiting momentum in the short run and partial mean reversion in the long run, and (2) agents do not know that fundamentals are hump-shaped and base their beliefs on parsimonious models that they fit to the available data? A class of parsimonious models leads to qualitatively similar biases and generates empirically observed patterns in asset prices and macroeconomic dynamics. First, parsimonious models will robustly pick up the short-term momentum in fundamentals but will generally fail to fully capture the long-run mean reversion. Beliefs will therefore be characterized by endogenous extrapolation bias and pro-cyclical excess optimism. Second, asset prices will be highly volatile and exhibit partial mean reversion--i.e., overreaction. Excess returns will be negatively predicted by lagged excess returns, P/E ratios, and consumption growth. Third, real economic activity will have amplified cycles. For example, consumption growth will be negatively auto-correlated in the medium run. Fourth, the equity premium will be large. Agents will perceive that equities are very risky when in fact long-run equity returns will co-vary only weakly with long-run consumption growth. If agents had rational expectations, the equity premium would be close to zero. Fifth, sophisticated agents--i.e., those who are assumed to know the true model--will hold far more equity than investors who use parsimonious models. Moreover, sophisticated agents will follow a counter-cyclical asset allocation policy. These predicted effects are qualitatively confirmed in U.S. data.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/cd0da99bdecbbf16df496bffa873d43731a4c297

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Citations in the corpus

Macroeconomic Analysis Without the Rational Expectations Hypothesis (2013, result): “Fuster et al. (2010, 2011, 2012) provide examples in which more complex dynamics of asset prices, consumption and investment are implied by RPE dynamics than would be associated with REE dynamics of the same models; here the suboptimality of forecasts results from estimation of lower-order…”
Asset Pricing in Production Economies with Extrapolative Expectations (2015, background): “As is well known, production-based asset pricing models face an even greater challenge than endowment-based models in explaining consumption and asset return behavior, as such models allow greater scope for endogenous consumption and dividend smoothing (see, e.g., Rouwenhorst, 1995; Jermann, 1998; L”
A Behavioral New Keynesian Model (2020, unknown): “Conceptually, it might be an optimal simple forecast based on past variables, such as π t = Ẽt [ πt+1| ( πτ , π CB τ ) τ≤t ] , as in Fuster et al. (2012).(74) Here Ẽt indicates that this need not be a completely optimal forecast.”
Learning from Inflation Experiences (2016, background): “Also related is the work by Fuster, Laibson, and Mendel (2010) and Fuster, Hebert, and Laibson (2011), who propose a model of “natural expectations” and demonstrate its ability to match hump-shaped dynamics in various economic time series.”
Psychology-based Models of Asset Prices and Trading Volume (2018, methodology): “More recent models include Fuster et al. (2012), Choi and Mertens (2013), Alti and Tetlock (2014), Hirshleifer et al. (2015), and Bordalo et al. (2017, 2018a).16 Models of cash-flow extrapolation predict that the past growth in an asset’s fundamentals will be negatively related to the asset’s…”
Expectations and Investment (2015, unknown): “Vissing-Jorgensen (2003) and Fuster et al (2011) are two recent Macro Annual papers that also address expectations formation and rationality.”