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January 2012 issue
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Clarida, Fuhrer
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Investment Dynamics with Natural Expectations

by Andreas Fustera, Benjamin Hebertband David Laibsonbc

Abstract

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.

 
Full article (PDF, 23 pages 556 kb)
Discussion by Alberto Alesina


a Federal Reserve Bank of New York
b Harvard University
c NBER