Measuring Biases in Expectation Formation
67 Pages Posted: 15 Jun 2018 Last revised: 8 Jun 2019
Date Written: May 24, 2019
We develop a framework for measuring biases in expectation formation. The basic insight is that under- and overreaction to new information is identified by the impulse response function of forecast errors. This insight leads to a simple and widely applicable measurement procedure. The procedure yields estimates of under- and overreaction to new information at different horizons. Our framework encompasses all major models of expectations, sheds light on existing approaches to measuring biases, and provides new empirical predictions. In an application to inflation expectations, we find that forecasters underreact to aggregate shocks but overreact to idiosyncratic shocks.
Keywords: expectation formation, bias, underreaction, overreaction
JEL Classification: C53, D83, D84, E70, G40
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