DP12028 Overpersistence Bias in Individual Income Expectations and its Aggregate Implications

Author(s): Filip Rozsypal, Kathrin Schlafmann
Publication Date: May 2017
Keyword(s): durable consumption, household income expectations, Savings
JEL(s): D14, D84, D91, E21, G02, H31
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12028

We study the role of household income expectations for consumption decisions. Using micro level data, we first document an systematic, income-related component in household income forecast errors. These systematic errors can be explained by a modest deviation from rational expectations, where agents overestimate the persistence of their income process. We then study the implications of this bias in a quantitative model. Low income households who overestimate the persistence of their income are too pessimistic about their future income. This has two effects. First, these households are unwilling to borrow to smooth their consumption even though their borrowing constraint is not binding, thereby allowing the quantitative model to match the distribution of liquid assets across the income distribution. Second, they have lower marginal propensities to consume than their fully rational counterparts. Disregarding the bias in income expectations thus leads standard models to overpredict the effectiveness of government stimulus payments.