Working Paper: CEPR ID: DP17447
Authors: Joo Cocco; Francisco Gomes; Paula Lopes
Abstract: We use panel data on expected and realized changes in household finances to studythe process of expectation formation and expectation errors. Households extrapolate fromimprovements in financial situation, but a deterioration in their finances is associated withan increased dispersion of forecasts. This increased dispersion leads to higher probabilitiesof both negative and positive forecast errors. Individuals who expect negative earningsshocks to revert too quickly save less and have a higher likelihood of being financiallyworse off again in the future. A calibrated life-cycle model quantifies the consumptionsmoothing and welfare implications of belief distortions.
Keywords: No keywords provided
JEL Codes: D84; G40; G50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Improvement in financial situation (G59) | Increased expectation of future improvement (D84) |
| Deterioration in financial situation (F65) | Increased dispersion in expectations (D84) |
| Deterioration in financial situation (F65) | Higher probabilities of expecting further deterioration and improvement (E32) |
| Expecting negative earnings shocks to revert too quickly (D84) | Less saving (E21) |
| Less saving (E21) | Increased likelihood of being financially worse off in the future (G51) |