Abstract:
Using micro-level data, we document a systematic, income-related component in household income forecast errors. We show that these errors can be formalized by a modest deviation from rational expectations, where agents overestimate the persistence of their income process. We then investigate the implications of these distortions on consumption and savings behavior and find two effects. First, these distortions allow an otherwise fully optimization-based quantitative model to match the empirical joint distribution of liquid assets and income. Second, the bias alters the distribution of marginal propensities to consume which makes government stimulus policies less effective.
