Natural Expectations and Macroeconomic Fluctuations

Abstract

A large body of empirical evidence suggests that beliefs systematically deviate from perfect rationality. Much of the evidence implies that economic agents tend to form forecasts that are excessively influenced by recent changes. We present a parsimonious quasi-rational model that we call natural expectations, which falls between rational expectations and (na�ve) intuitive expectations. (Intuitive expectations are formed by running growth regressions with a limited number of right-hand-side variables, and this leads to excessively extrapolative beliefs in certain classes of environments). Natural expectations overstate the long-run persistence of economic shocks. In other words, agents with natural expectations turn out to form beliefs that don't sufficiently account for the fact that good times (or bad times) won't last forever. We embed natural expectations in a simple dynamic macroeconomic model and compare the simulated properties of the model to the available empirical evidence. The model's predictions match many patterns observed in macroeconomic and financial time series, such as high volatility of asset prices, predictable up-and-down cycles in equity returns, and a negative relationship between current consumption growth and future equity returns.

Behavioral learning equilibria

“…Branch (2006) gives an excellent survey and argues that RPE is a natural alternative to rational expectation equilibrium, because it is to some extent consistent with Muth's original hypothesis of REE while allowing for bounded rationality by restricting the class of perceived laws of motion. Fuster et al (2010) and Fuster et al (2011Fuster et al ( , 2012 propose a concept of natural expectations, where agents use simple, misspecified models, e.g., linear autoregressive models, for their perceived law of motion. They argue that economists and non-economists -statisticians, professional forecasters, and firms-regularly make some simplifications of models.…”

Housing Booms and Busts and Local Fiscal Policy

“…The possibility of agents developing irrational beliefs in this context quickly comes to mind (e.g., Glaeser and Nathanson, 2015). Various studies demonstrate that people do not readily forecast mean reversion processes of variables that grow sustainably over quite a long period (Fuster et al, 2010), which is what occurred in our case.…”

We expect stocks to rise, but we do not know when and which ones: Excessive optimism in predicting future stock indices returns

“…They found that analysts tend to systematically misinterpret new information about the investment; they underreact to negative information, but overreact to positive information. The issue of misinterpreting new information and past historical changes is also one of the main explanations of excessive optimism in works of Fuster, Herbert, and Laibson (2011;2012) and Fuster, Laibson, and Mendel (2010). In these papers, the authors suggest that in the process of predicting future prices of assets or markets, subjects use both rational analytic strategies and more simplex heuristic models, which fasten the reasoning about the dynamics of fundamental economic factors.…”