Natural Expectations, Macroeconomic Dynamics, And Asset Pricing

How does an economy behave if fundamentals are truly hump-shaped, exhibiting momentum in the short run and partial mean reversion in the long run, and agents do not know that fundamentals are hump-shaped and base their beliefs on parsimonious models that they fit to the available data? A class of parsimonious models leads to qualitatively similar biases and generates empirically observed patterns in asset prices and macroeconomic dynamics. First, parsimonious models will robustly pick up the short-term momentum in fundamentals but will generally fail to fully capture the long-run mean reversion. Second, asset prices will be highly volatile and exhibit partial mean reversion - i.e., overreaction. Third, real economic activity will have amplified cycles. For example, consumption growth will be negatively auto-correlated in the medium run.

Provided by: National Bureau of Economic Research Topic: CXO Date Added: Aug 2011 Format: PDF

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