Over-/Underreaction and Judgment Noise in Expectation Formation Link
In forecast surveys of aggregate macroeconomic and financial variables, the correlation between forecast errors and forecast revisions is positive at the consensus level, but negative at the individual level. Past literature has interpreted this discrepancy as evidence of underreaction to news at the aggregate level and overreaction at the individual level. In this paper, I challenge this view by arguing that noise in predictive judgment can account for the difference. Using a stylized model, I examine how introducing judgment noise at the individual level changes the interpretation of the correlation coefficients. A negative coefficient at the individual level no longer necessarily means overreaction. Using forecast survey data, I provide evidence that judgment noise is large enough to reconcile the difference between the two coefficients. The structural parameter measuring over-/underreaction mainly points to underreaction, regardless of whether the model matches correlation coefficients at the individual or aggregate level.
Adaptive Expectations and Over-/Under-reaction to New Information
This article first investigates whether adaptive expectation implies over- or under-reaction to new information. It is shown that the occurrence of over- or under-reaction using adaptive expectations is contingent on both the weighting parameter used in forecasts and the persistence of the associated actual variable. Furthermore, compared to the generalized diagnostic expectations model, the adaptive expectations framework can better match the under-reaction to new information for several variables, as measured by the correlations between forecast errors and forecast revisions. This advantage stems from the capacity of adaptive expectations to allow varying degrees of stickiness in expectations, a feature not present in the generalized diagnostic expectations model. Additionally, adaptive expectations account for two empirical phenomena: an increasing degree of over-reaction with forecast horizons and an initial under-reaction followed by over-shooting upon shocks.