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LOCK-IN OF EXTRAPOLATIVE EXPECTATIONS IN AN ASSET PRICING MODEL

Published online by Cambridge University Press:  24 March 2006

KEVIN J. LANSING
KEVIN J. LANSING
Affiliation:
Federal Reserve Bank of San Francisco
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Abstract

This paper examines an agent's choice of forecast method within a standard asset pricing model. A representative agent may choose: (1) a fundamentals-based forecast that employs knowledge of the dividend process, (2) a constant forecast that is based on a simple long-run average, or (3) a time-varying forecast that extrapolates from the last observation. I show that an agent who is concerned about minimizing forecast errors may inadvertently become “locked-in” to an extrapolative forecast. In particular, the initial use of extrapolation alters the law of motion of the forecast variable so that the agent perceives no accuracy gain from switching to one of the alternative forecast methods. The model can generate excess volatility of stock prices, time-varying volatility of returns, long-horizon predictability of returns, bubbles driven by optimism about the future, and sharp downward movements in stock prices that resemble market crashes.

Keywords

Asset PricingDistorted BeliefsExpectationsBubbles
Type
ARTICLES
Information
Macroeconomic Dynamics , Volume 10 , Issue 3 , June 2006 , pp. 317 - 348
Copyright
© 2006 Cambridge University Press

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