Klaus Adam is Nuffield Professor of Economics and a Professorial Fellow at Nuffield College. He is also Research Professor at the Deutsche Bundesbank, a member of the Academic Advisory Board of the German Ministry of Finance, and Scientific Chair of the Euro Area Business Cycle Network (EABCN). His research work focuses on monetary and fiscal policy making, as well as on issues related to learning and the formation of expectations with applications to asset pricing and business cycle dynamics.
Do Survey Expectations of Stock Returns Reflect Risk-Adjustments?
Motivated by the observation that survey expectations of stock returns are inconsistent with rational return expectations under real-world probabilities, we investigate whether alternative expectations hypotheses entertained in the asset pricing literature are consistent with the survey evidence. We empirically test (1) the notion that survey forecasts constitute rational but risk-neutral forecasts of future returns, and (2) the notion that survey forecasts are ambiguity averse/robust forecasts of future returns. We find that these alternative hypotheses are also strongly rejected by the data, albeit for different reasons. Hypothesis (1) is rejected because survey return forecasts are not in line with risk-free interest rates and because survey expected excess returns are predictable. Hypothesis (2) is rejected because agents are not always pessimistic about future returns, instead often display overly optimistic return expectations. We speculate as to what kind of expectations theories might be consistent with the available survey evidence.
G120, survey expectations, expected stock returns
Optimal Trend Inflation
Sticky price models featuring heterogeneous firms and systematic firm-level productivity trends deliver radically different predictions for the optimal inflation rate than their popular homogenous-firm counterparts: (1) the optimal steady-state inflation rate generically differs from zero and (2) inflation optimally responds to productivity disturbances. We show this by aggregating a heterogenous-firm model with sticky prices in closed form. Using firm-level data from the U.S. Census Bureau, we estimate the historically optimal inflation path for the U.S. economy. In the year 1977, the optimal inflation rate stood at 1.5%, but subsequently declined to around 1.0% in the year 2015. Inflation rates up to twice these numbers can be rationalized if one considers product demand elasticities more in line with the trade literature or if one considers firms that (partially) index prices to lagged inflation rates.
Investors' subjective capital gains expectations are a key element explaining stock price fluctuations. Survey measures of these expectations display excessive optimism (pessimism) at market peaks (troughs). We formally reject the hypothesis that this is compatible with rational expectations. We then incorporate subjective price beliefs with such properties into a standard asset-pricing model with rational agents (internal rationality). The model gives rise to boom- bust cycles that temporarily delink stock prices from fundamentals and quantitatively replicates many asset-pricing moments. In particular, it matches the observed strong positive correlation between the price dividend ratio and survey return expectations, which cannot be matched by rational expectations.
Optimal sovereign default
American Economic Journal: Macroeconomics
When is it optimal for a fully committed government to default on its legal repayment obligations Considering a small open economy with domestic production risk and noncontingent government debt, we show that it is ex ante optimal to occasionally deviate from the legal repayment obligation and to repay debt only partially. This holds true even if default generates significant deadweight costs ex post. A quantitative analysis reveals that default is optimal only in response to persistent disaster-like shocks to domestic output. Applying the framework to the situation in Greece, we find that optimal default policies suggest a considerably larger and more timely default than the one actually implemented in the year 2012. (JEL E23, E62, F41, H63).