Lock-in of Extrapolative Expectations in an Asset Pricing Model

2004-06 | October 1, 2005

This paper examines an agent’s choice of forecast method within a standard asset pricing model. To make a conditional forecast, a representative agent may choose one of the following: (1) a rational (or fundamentals-based) forecast that employs knowledge of the stochastic process governing dividends, (2) a constant forecast based on a simple long-run average of the forecast variable, or (3) a time-varying forecast that extrapolates from the last observation of the forecast variable. I show that a representative 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. Under extrapolative expectations, 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. All of these features appear to be present in long-run U.S. stock market data.

Article Citation

J. Lansing, Kevin. 2004. “Lock-in of Extrapolative Expectations in an Asset Pricing Model,” Federal Reserve Bank of San Francisco Working Paper 2004-06. Available at https://doi.org/10.24148/wp2004-06

About the Author
Kevin Lansing
Kevin Lansing is a senior research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Kevin Lansing