Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

73 Pages Posted: 29 Aug 2011 Last revised: 30 Aug 2011

See all articles by Andreas Fuster

Andreas Fuster

Swiss National Bank - Financial Stability

Benjamin Hebert

Stanford University

David Laibson

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: August 2011

Abstract

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.

Suggested Citation

Fuster, Andreas and Hebert, Benjamin M. and Laibson, David I., Natural Expectations, Macroeconomic Dynamics, and Asset Pricing (August 2011). NBER Working Paper No. w17301, Available at SSRN: https://ssrn.com/abstract=1918632

Andreas Fuster (Contact Author)

Swiss National Bank - Financial Stability ( email )

Boersenstrasse 15
Zurich, CH-8022
Switzerland

Benjamin M. Hebert

Stanford University ( email )

Stanford, CA 94305
United States

David I. Laibson

Harvard University - Department of Economics ( email )

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Room M-14
Cambridge, MA 02138
United States
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National Bureau of Economic Research (NBER) ( email )

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