Natural Expectations, Macroeconomic Dynamics, and Asset Pricing
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.
We are grateful to Daron Acemoglu, Nicholas Barberis, John Beshears, Markus Brunnermeier, John Campbell, James Choi, Larry Christiano, John Driscoll, Emmanuel Farhi, Kenneth French, Xavier Gabaix, Stefano Giglio, Lars Peter Hansen, Blake LeBaron, Greg Mankiw, Joshua Schwartzstein, Andrei Shleifer, Jeremy Stein, Jim Stock, Michael Woodford, our discussants Marty Eichenbaum and George Evans, and seminar/conference participants for helpful comments and discussions. We are indebted to Brendan Price and Fernando Yu for excellent research assistance. David Laibson acknowledges support from the NIA (P01AG005842). The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Andreas Fuster & Benjamin Hebert & David Laibson, 2012. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Macroeconomics Annual, University of Chicago Press, vol. 26(1), pages 1 - 48.
Natural Expectations, Macroeconomic Dynamics, and Asset Pricing, Andreas Fuster, Benjamin Hebert, David Laibson. in NBER Macroeconomics Annual 2011, Volume 26, Acemoglu and Woodford. 2012