Investment Dynamics with Natural Expectations
by Andreas Fustera, Benjamin Hebertband David Laibsonbc
We study an investment model in which agents have the
wrong beliefs about the dynamic properties of fundamentals.
Specifically, we assume that agents underestimate the rate of
mean reversion. The model exhibits the following six properties:
(i) Beliefs are excessively optimistic in good times and
excessively pessimistic in bad times. (ii) Asset prices are too
volatile. (iii) Excess returns are negatively autocorrelated. (iv)
High levels of corporate profits predict negative future excess
returns. (v) Real economic activity is excessively volatile; the
economy experiences amplified investment cycles. (vi) Corporate
profits are positively autocorrelated in the short run and
negatively autocorrelated in the medium run. The paper provides
an illustrative model of animal spirits, amplified business
cycles, and excess volatility.
JEL Codes: E22, G1.
(PDF, 23 pages 556 kb)
Discussion by Alberto Alesina
a Federal Reserve Bank of New York
b Harvard University