Evidence on Expectations of Household Finances

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.