Yellow Pad Report

A new and exclusive Sundstrom blog feature! The Yellow Pad is our weekly Economics Department seminar series at Santa Clara University.

Yuriy Gorodnichenko (UC-Berkeley), "How Do Firms Form Their Expectations? New Survey Evidence" (with Olivier Coibion and Saten Kumar), April 8, 2015

We were quite fortunate to have Yuriy Gordnichenko take time to drop by Santa Clara and present his very interesting paper on expectations formation. He and his co-authors surveyed a large sample of New Zealand firms to ascertain how accurate their forecasts of key macroeconomic variables are, and what factors influence the degree of forecast error.

A better title might have been: "Why are so many firms ignorant of basic macroeconomic facts?" The authors find that a large percentage of top managers are badly misinformed about inflation. In particular, like ordinary consumers, managers tend to believe that the inflation rate is much greater than it actually is. Whereas the NZ central bank has been pretty successfully targeting inflation at around 2% for about 25 years, lots of decision makers in small- and medium-sized firms there seem to think inflation is on the order of 10% or higher.

What gives? Yuriy and coauthors attribute the errors to rational inattention. That is, the firms that are ignorant about inflation have no good reason to become better informed. Whereas, the firms that need to care more about prices because of their market circumstances tend to gather better information and form more realistic perceptions and forecasts.

This paper represents my kind of macro. Go out and get some real data on how people make decisions. Still, puzzles remain. Firm managers seem to have much more accurate knowledge and forecasts of unemployment and economic growth than inflation. But are these variables that much more important than inflation to their decision making? The rational inattention story would seem to have to answer yes. But my conjecture is that (1) none of these macro variables matter all that much to most firms, and (2) when it comes to inflation, managers are subject to many of the same biases and heuristics that afflict ordinary folks: They notice the price of gasoline or milk going up, and they overlook the price of bananas and tablets going down. Yuriy and colleagues do show that firms update their expectations when given new information they deem reliable. So managers are not mulishly ignorant. Just pretty damn ignorant.