Overpersistence Bias in Individual Income Expectations and its Aggregate Implications

69 Pages Posted: 15 May 2017

See all articles by Filip Rozsypal

Filip Rozsypal

London School of Economics & Political Science (LSE)

Kathrin Schlafmann

Copenhagen Business School - Department of Finance; Stockholm University - Institute for International Economic Studies (IIES); Centre for Economic Policy Research (CEPR)

Date Written: May 2017

Abstract

We study the role of household income expectations for consumption decisions. Using micro level data, we first document an systematic, income-related component in household income forecast errors. These systematic errors can be explained by a modest deviation from rational expectations, where agents overestimate the persistence of their income process. We then study the implications of this bias in a quantitative model. Low income households who overestimate the persistence of their income are too pessimistic about their future income. This has two effects. First, these households are unwilling to borrow to smooth their consumption even though their borrowing constraint is not binding, thereby allowing the quantitative model to match the distribution of liquid assets across the income distribution. Second, they have lower marginal propensities to consume than their fully rational counterparts. Disregarding the bias in income expectations thus leads standard models to overpredict the effectiveness of government stimulus payments.

Keywords: durable consumption, household income expectations, Savings

JEL Classification: D14, D84, D91, E21, G02, H31

Suggested Citation

Rozsypal, Filip and Schlafmann, Kathrin, Overpersistence Bias in Individual Income Expectations and its Aggregate Implications (May 2017). CEPR Discussion Paper No. DP12028, Available at SSRN: https://ssrn.com/abstract=2968369

Filip Rozsypal (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Kathrin Schlafmann

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, 2000
Denmark

Stockholm University - Institute for International Economic Studies (IIES) ( email )

Stockholm, SE-10691
Sweden

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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