Imperfect Macroeconomic Expectations: Evidence and Theory

Abstract

We document a new fact about expectations: in response to the main shocks driving the business cycle, expectations under-react initially but over-shoot 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 under-extrapolation 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.

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