Natural Expectations, Macroeconomic Dynamics, and Asset Pricing
Chapter in NBER book NBER Macroeconomics Annual 2011, Volume 26 (2012), Daron Acemoglu and Michael Woodford, editors (p. 1 - 48)
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.
Document Object Identifier (DOI): 10.1086/663989This chapter first appeared as NBER working paper w17301, Natural Expectations, Macroeconomic Dynamics, and Asset Pricing, Andreas Fuster, Benjamin Hebert, David Laibson
Commentary on this chapter:
Comment, Martin Eichenbaum
Comment, George W. Evans
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