NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

Andreas Fuster, Benjamin Hebert, David Laibson

Chapter in NBER book NBER Macroeconomics Annual 2011, Volume 26 (2012), Daron Acemoglu and Michael Woodford, editors (p. 1 - 48)
Conference held April 8-9, 2011
Published in August 2012 by University of Chicago Press
© 2012 by the National Bureau of Economic Research
in NBER Book Series NBER Macroeconomics Annual

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 procyclical excess optimism. Second, asset prices will be highly volatile and exhibit partial mean reversion—that is, 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—that is, 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 countercyclical asset allocation policy. These predicted effects are qualitatively confirmed in US data.

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A data appendix is available at http://www.nber.org/data-appendix/c12404/appendix.pdf

This paper was revised on September 8, 2014

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Document Object Identifier (DOI): 10.1086/663989

This chapter first appeared as NBER working paper w17301, Natural Expectations, Macroeconomic Dynamics, and Asset Pricing, Andreas Fuster, Benjamin Hebert, David Laibson
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