Evidence on expectations of household finances

Subject

Finance

Publishing details

Social Sciences Research Network

Authors / Editors

Cocco J; Gomes F; Lopes P

Biographies

Publication Year

2019

Abstract

We use a long panel with information on expected and realized changes in individual finances to study the process of expectation formation and expectation errors, controlling for individual fixed effects. We find that, following improvements in financial situation, individuals tend to form extrapolative expectations and are excessively optimistic about the future. However, following a deterioration in financial situation, there is an increase in the dispersion of forecasts: individuals increase both their subjective probability of a future deterioration (consistent with extrapolative behavior) and the probability of a future improvement (mean-reversion). On average the second effect dominates after an earnings decline, with individuals expecting too much mean-reversion. This optimism is reflected in lower savings and higher borrowing, with significant negative implications for future household finances.

Series

Social Sciences Research Network