Measuring Under- and Overreaction in Expectation Formation

79 Pages Posted: 15 Jun 2018 Last revised: 9 Jun 2022

See all articles by Simas Kucinskas

Simas Kucinskas

Humboldt University of Berlin

Florian S. Peters

University of Amsterdam

Date Written: June 9, 2022

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. Our measurement 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. We illustrate how our approach can be used to (i) quantify the importance of different biases; (ii) estimate theoretical models; and (iii) shed light on existing empirical approaches and puzzles.

Keywords: expectation formation, bias, underreaction, overreaction

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

Suggested Citation

Kucinskas, Simas and Peters, Florian S., Measuring Under- and Overreaction in Expectation Formation (June 9, 2022). Available at SSRN: https://ssrn.com/abstract=3188065 or http://dx.doi.org/10.2139/ssrn.3188065

Simas Kucinskas (Contact Author)

Humboldt University of Berlin

Dorotheenstrasse 1
Berlin, Berlin 10099
Germany

HOME PAGE: http://www.simaskucinskas.com

Florian S. Peters

University of Amsterdam ( email )

Plantage Muidergracht 12
Amsterdam, 1018 TW
Netherlands

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