Belief Foundations and Waves of Optimism and Pessimism: Response to Historical Trends, Disaster Risk and Personal Experiences

• Applicant: Professorin Ester Faia, Ph.D.
• Subject Area: Economic Policy, Applied Economics ; Economic and Social History ; Economic Theory
• Term: from 2019 to 2023
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 415981260

Expectations play a key role in economic decision making under uncertainty. The academic literature on the causes and consequences of the recent financial crises has put much emphasis on expectation formation and in particular on the forces behind waves of optimism and pessimism. The latter indeed can be a key element behind the boom and bust in asset prices, or behind the excessive leverage, which typically takes place prior to a financial crisis, and can play a crucial role in determining how fast and to what extent the economy recovers. Equally, expectations about employment prospects can change in response to large unexpected shocks, such as deep recessions, for example, by reducing labor force participation, which can in turn affect the long run equilibrium in the labor market. Expectations about aggregate outcomes vary significantly across countries and regions, even those experiencing similar economic policies, and thereby can affect their growth paths. Studying the expectation formation process seems therefore of primary importance to gain an understanding of the occurrence of crises and more in general of how economies respond in the long run to large unexpected shocks. This project has two goals, which both require a data collection effort aimed at studying the evolution of expectations on labor and financial markets, respectively. The first project will make use of employer-employee matched data from Denmark to examine the link between expectations of labor market performance to personal experiences, such as lay-offs or lack of career advancement in the family. Such experiences may influence individuals’ perceived probability of unemployment or expectations of career advancement, which may affect their labor force participation decisions or their investment in human capital. The second project estimates the link between expectations on the behavior of a broad set of financial variables (such as house or asset valuations and interest rates) and disaster risk. In this case we will use survey data from Italy, whose geology makes the country prone to frequent, unexpected and uninsurable natural disasters, like earthquakes. Both projects will allow us to test whether major event in an individual’s personal or historical experiences affect expectations, and more specifically, under what conditions waves of optimism and pessimism may be activated. Finally, we will develop a theoretical model of expectation formation based on the empirical evidence drawn from the new data sets we plan to construct for our studies. Specifically, we will consider two hypotheses about expectation formation. Under the first hypothesis, waves of optimism and pessimism are seen as the outcome of agents’ maximizing behavior under ambiguity aversion or ambiguity seeking. Under the second hypothesis, expectations change from optimism to pessimism because of strategic interaction among agents, due to higher order expectations.

• DFG Programme: Priority Programmes
• Subproject of: SPP 1859: Experience and Expectation: Historical Foundations of Economic Behaviour
• International Connection: USA
• Co-Investigator: Professorin Stefania Albanesi, Ph.D.