‘The Island Man's Behavior’: Some Microfoundations of How Households Form Macroeconomic Expectations

Abstract:     
This paper investigates how households form expectations about the macroeconomy. We outline a theoretical model whereby households form subjective expectations about the aggregate economy based on personal finance expectations as a reference point. The speed of updating the expectations reflects the households' willingness to incur transactions costs and may be state‐varying. This forms the basis of the empirical analysis using survey‐based US household data. The results indicate that while household expectations of the aggregate economy adjust to personal finance expectations, it is slow and non‐linear, thereby, explaining the persistence of relative effects in the context of the Lucas‐Phelps Island model.

Number of Pages in PDF File: 22

Accepted Paper Series