Measuring Under- and Overreaction in Expectation Formation

Abstract

We develop a framework for measuring under- and overreaction in expectation formation. The basic insight is that under- and overreaction to new information is identified (up to sign) by the impulse response function of forecast errors. This insight leads to a widely applicable measurement procedure. The procedure yields estimates of under- and overreaction to different shocks at various horizons. In an application to inflation expectations, we find that forecasters underreact to aggregate shocks but overreact to idiosyncratic shocks. Finally, we illustrate how our approach can be used to (i) calibrate theoretical models; and (ii) shed light on existing empirical puzzles.

Keywords: expectation formation, bias, underreaction, overreaction

JEL Classification: C53, D83, D84, E70, G40