Friday, November 30, 2012

Inflation expectations and rational behavior

Ask people on the street (à 24-hour news channel that needs to fill time) about the inflation rate, and I am quite sure you get an very upward biased estimate. Or at least this is what I would have expected, but the data seems to contradict me: comparing US inflation expectations from the University of Michigan Consumer Survey and the realized CPI, there is no obvious bias visible, meaning they seem to have rational expectations:

However, are these consumers rational all the way, that is, do their actions follow their expectations? Olivier Armantier, Wändi Bruine de Bruin, Giorgio Topa, Wilbert van der Klaauw and Basit Zafar design an experiment where payoffs depend on future inflation. By and large, participants seems to act in a way that is consistent both qualitatively and quantitatively with expect utility theory. The only ones that stray away and not surprisingly less educated consumers, but their impact is rather small (in numbers, and me now that zero-intelligence traders have no impact on markets). My faith in the US consumer is restored.


Anonymous said...

There is another literature (from Experimental Economics) suggesting that more people behave as if Expected Utility (55%) rather than as if Prospect Theory (45%), but not by much. Do you have any comments on Mixture models?

Economic Logician said...

That really depends on the research question. My reading of the literature is that the presence of people deviating from standard expected utility maximization does not have much of an impact on the behavior of markets, unless the deviators do really weird stuff. So if you are interested in the impact of policy on markets, we are doing fine with standard theory in this respect.

If you are looking for household welfare, this may be a different question. After all, you have people potentially fooling themselves, and you may want to do something about that. Then it becomes important to identify what their beliefs are, how they act on them and then how policy can help them.