Working Paper: NBER ID: w27308
Authors: Georgemarios Angeletos; Zhen Huo; Karthik A. Sastry
Abstract: We document a new fact about expectations: in response to the main shocks driving the business cycle, expectations underreact initially but overshoot later on. We show how previous, seemingly conflicting, evidence can be understood as different facets of this fact. We finally explain what the cumulated evidence means for macroeconomic theory. There is little support for theories emphasizing underextrapolation or two close cousins of it, cognitive discounting and level-K thinking. Instead, the evidence favors the combination of dispersed, noisy information and over-extrapolation.
Keywords: macroeconomic expectations; business cycles; informational frictions; overextrapolation
JEL Codes: E03; E7; G02
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Initial shocks (E32) | Sluggish responses in unemployment expectations (E24) |
| Initial shocks (E32) | Sluggish responses in inflation expectations (E31) |
| Sluggish responses in unemployment expectations (E24) | Overshooting of actual outcomes (E32) |
| Sluggish responses in inflation expectations (E31) | Overshooting of actual outcomes (E32) |
| Dispersed noisy information and overextrapolation (D80) | Dynamic pattern in forecast errors (C22) |
| Forecast errors (C53) | Positively correlated with past revisions (C59) |