What to Expect When Everyone is Expecting: Self-Fulfilling Expectations and Asset-Pricing Puzzles

Abstract

We study an economy without bubbles in which expectations about future discount rates can become self-fulfilling because asset valuations redistribute wealth across different investor cohorts. For such redistribution to take place, the wealth of arriving and existing cohorts must react differently to discount rates, and in addition only the existing agents be marginal in financial markets. The self-fulfilling nature of discount rate expectations means that the economy can address several well documented empirical asset pricing facts (excessive volatility, return predictability, low interest rate level and volatility), while all real quantities (aggregate consumption and dividend growth) are smooth.

Keywords: asset pricing, self-fulfilling expectations, sunspot equilibria, equity premium puzzle, excess volatility puzzle, inequality

JEL Classification: G01, G12