Comments on Natural Expectations, Macroeconomic Dynamics and Asset Pricing

Expectations clearly play a central role in modern macroeconomics. Households and …rms are assumed to be dynamic optimizers, making decisions about work, consumption, savings, production and investment, based in part on current economic conditions, but also to a great extent on the future state of the economy. Thus, in particular, household saving and portfolio decisions depend on expected future interest rates, in‡ation and taxes and on the likely future trajectory of equity dividends and prices. Because of the key role of expectations in economics and …nance, theories of expectations have been central to modern economic theory. Since the rational expectations (RE) revolution of the 1970s, associated with John Muth, Robert Lucas and Thomas Sargent, the benchmark theory has been that expectations are formed rationally, in the sense that they are consistent with the true model and yield forecast errors that are orthogonal to agents’information sets. In their paper in this volume, Andreas Fuster, Benjamin Hebert and David Laibson (FHL) present an asset-pricing model in which RE is replaced by “Natural Expectations”(NE). Under NE agents misspecify the time-series model in a “natural” way: they chose a parsimonious model of dividends that omits longer lags. This captures short-run dynamics but misses longrun mean reversion. An earlier paper, Fuster et al. (2010) made similar arguments about other macroeconomic time-series.1 Taken together, the