Tanja Linta (Toulouse School of Economics) presented today at the 78th Economic Workshop of the Croatian National Bank her paper “Overreaction in expectations with endogenous feedback”. The paper examines expectation biases in an environment characterised by feedback loops between expectations and outcomes. In a forecasting experiment, the author provides evidence that, while individuals systematically overreact to recent information, their overreaction is mitigated by stabilising general equilibrium feedback mechanisms. A simple theoretical model that includes costly information processing shows that such mitigation is only possible if agents recognise the existence of a feedback loop and adapt their behaviour accordingly, thereby amplifying its stabilising effects. Within the framework of a neo-Keynesian approach, a stronger stabilising feedback loop that reduces the forecast bias accelerates the convergence of endogenous variables towards a rational expectations equilibrium.

However, they do not eliminate overreaction, which results in excessive volatility in inflationary responses to exogenous shocks. This implies that the monetary policy response to inflation shocks must be more aggressive in order to induce the same stabilising effects as under rational expectations.