Overreaction in Expectations with Endogenous Feedback

This paper measures biases in expectations within environments characterized by feedback loops between expectations and outcomes. Through a forecasting experiment, I provide evidence that although individuals systematically overreact to recent information, this overreaction is mitigated by stabilizing general equilibrium feedback. A simple theoretical model incorporating costly information processing shows that such a mitigation is feasible only if agents recognize the existence of feedback and adjust their behavior accordingly, thereby amplifying its stabilizing effects. Within the New Keynesian framework, stronger stabilizing feedback that attenuates the forecasting bias accelerates the convergence of endogenous variables to the rational expectations equilibrium. However, it does not eliminate overreaction, resulting in excess volatility in inflation responses to exogenous shocks. Consequently, monetary policy needs to respond more aggressively to an inflationary shock to achieve the same stabilizing effects as under rational expectations.