Evidence on Expectations of Household Finances

65 Pages Posted: 30 Apr 2019 Last revised: 20 Feb 2020

See all articles by Joao F. Cocco

Joao F. Cocco

London Business School; Centre for Economic Policy Research (CEPR)

Francisco Gomes

London Business School

Paula Lopes

Financial Markets Group, LSE

Date Written: January 30, 2020

Abstract

We use a long panel with information on expected and realized changes in household finances to study the process of expectation formation and expectation errors, controlling for individual fixed effects. We find that, following improvements in financial situation, individuals tend to form extrapolative expectations and they are excessively optimistic about the future. However, following a deterioration, there is an increase in the dispersion of forecasts, with increases in the expectation of a further deterioration (consistent with extrapolative behavior) and of a future improvement (consistent with mean reversion). We show that these expectation patterns are in line with observed savings behavior. When individuals expect mean reversion, they are too optimistic about the future; they reduce their savings and increase their borrowing, and they are more likely to find themselves financially worse off again in the future.

Suggested Citation

Cocco, João F. and Gomes, Francisco and Lopes, Paula, Evidence on Expectations of Household Finances (January 30, 2020). Available at SSRN: https://ssrn.com/abstract=3362495 or http://dx.doi.org/10.2139/ssrn.3362495

João F. Cocco

London Business School ( email )

Sussex Place
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Centre for Economic Policy Research (CEPR)

London
United Kingdom

Francisco Gomes (Contact Author)

London Business School ( email )

Finance Department
Sussex Place - Regent's Park
London NW1 4SA
United Kingdom

HOME PAGE: http://sites.google.com/view/francisco-gomes/home

Paula Lopes

Financial Markets Group, LSE ( email )

Houghton Street
London WC2A 2AE
United Kingdom

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