Optimal Expectations / Markus K. Brunnermeier, Jonathan A. Parker.

Format:

Book

Author/Creator:

Brunnermeier, Markus K.

Contributor:

National Bureau of Economic Research.

Parker, Jonathan A.

Series:

Working Paper Series (National Bureau of Economic Research) no. w10707.

NBER working paper series no. w10707

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2004.

Summary:

This paper introduces a tractable, structural model of subjective beliefs. Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they believe that better outcomes are more likely. On the other hand, biased expectations lead to poorer decisions and worse realized outcomes on average. Optimal expectations balance these forces by maximizing average felicity. A small bias in beliefs typically leads to first-order gains due to increased anticipatory utility and only to second-order costs due to distorted behavior. We show that in a portfolio choice problem, agents overestimate the return on their investment and exhibit a preference for skewness. In general equilibrium, agents' prior beliefs are endogenously heterogeneous. Finally, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic.

Notes:

Print version record

August 2004.