TY - JOUR AU - Fuster, Andreas AU - Hebert, Benjamin AU - Laibson, David TI - Natural Expectations, Macroeconomic Dynamics, and Asset Pricing JF - National Bureau of Economic Research Working Paper Series VL - No. 17301 PY - 2011 Y2 - August 2011 DO - 10.3386/w17301 UR - http://www.nber.org/papers/w17301 L1 - http://www.nber.org/papers/w17301.pdf N1 - Author contact info: Andreas Fuster Swiss National Bank Boersenstrasse 15 CH-8022 Zurich Switzerland E-Mail: andreas.fuster@gmail.com Benjamin M. Hébert Graduate School of Business Stanford University 655 Knight Way Stanford, CA 94305 Tel: 617/869-8502 E-Mail: bhebert@stanford.edu David Laibson Department of Economics Littauer M-12 Harvard University Cambridge, MA 02138 Tel: 617/496-3402 Fax: 617/495-8570 E-Mail: dlaibson@gmail.com M1 - published as Andreas Fuster, Benjamin Hebert, David Laibson. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," in Daron Acemoglu and Michael Woodford, editors, "NBER Macroeconomics Annual 2011, Volume 26" University of Chicago Press (2012) M3 - presented at "26th Annual Conference on Macroeconomics", April 8-9, 2011 AB - How does an economy behave if (1) fundamentals are truly hump-shaped, exhibiting momentum in the short run and partial mean reversion in the long run, and (2) 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. Beliefs will therefore be characterized by endogenous extrapolation bias and pro-cyclical excess optimism. Second, asset prices will be highly volatile and exhibit partial mean reversion--i.e., overreaction. Excess returns will be negatively predicted by lagged excess returns, P/E ratios, and consumption growth. Third, real economic activity will have amplified cycles. For example, consumption growth will be negatively auto-correlated in the medium run. Fourth, the equity premium will be large. Agents will perceive that equities are very risky when in fact long-run equity returns will co-vary only weakly with long-run consumption growth. If agents had rational expectations, the equity premium would be close to zero. Fifth, sophisticated agents--i.e., those who are assumed to know the true model--will hold far more equity than investors who use parsimonious models. Moreover, sophisticated agents will follow a counter-cyclical asset allocation policy. These predicted effects are qualitatively confirmed in U.S. data. ER -