Abstract:

This dissertation examines the decision making processes of households and the behavioral biases that influence those decisions.

The first chapter provides evidence of pessimism in household macroeconomic forecasts. Household surveys indicate that lower income and lesser educated households have upward-biased forecasts of future inflation and overly bleak unemployment expectations. The inflation and unemployment experiences of these demographic groups cannot alone account for this pessimism in macroeconomic forecasts. The distribution of responses for high school educated households includes more extreme positive inflation forecasts. For survey questions with categorical responses, the lesser educated and lower income households also made more pessimistic predictions including higher unemployment and worsening business conditions. The responses to all forecast questions taken together suggest that lower income and lesser educated households systematically forecast macroeconomic variables with more pessimism than higher income and more educated households.

The second chapter builds upon this survey evidence of pessimism by presenting a model which shows how pessimistic forecasts might be optimal. Evidence that lower income and lesser educated households exhibit difficulties with self-control in making decisions about consumption and savings suggests that pessimism in macroeconomic expectations may serve as a self-regulation device. This chapter develops a life cycle consumption model with stochastic income and belief manipulation. Under plausible parameter values, the model shows that the optimal response to self-control problems is to become defensively pessimistic about future prospects - perceiving a 18% lower mean transitory shock to income. The lack of commitment leads to a small expected utility loss, however, this loss is nearly fully recovered by the defensively pessimistic beliefs about future income. Pessimistic beliefs raise utility by distorting consumption decisions causing households to save more than they otherwise would absent pessimism. This suggests that while household expectations formation processes are not rational, they can be understood as welfare-enhancing distorted forecasts.

The third chapter examines myopic loss aversion and its role in explaining the equity premium puzzle and the home bias puzzle. Myopic loss aversion has been used to explain why a high equity premium might be consistent with plausible levels of risk aversion. The intuition is that the different utility impact of wealth gains and losses leads myopic loss averse investors to behave similarly to investors with high risk aversion. But if so, should these agents not perceive larger gains from international diversification than standard expected utility preference agents with plausible levels of risk aversion? They might not because comovements in international stock markets are asymmetric: correlations are higher in market downturns than in upturns. This asymmetry dampens the gains from diversification relatively more for myopic loss averse investors. We analyze the portfolio problem of such an investor who has to choose between home and foreign equities in the presence of asymmetric comovement in returns. Perhaps surprisingly, in the context of the home bias puzzle we find that myopic loss averse investors behave similarly to those with standard expected utility preferences and plausible levels of risk aversion.