Christopher Gust, Edward Herbst, and David Lopez-SalidoUnder finite horizon planning, households and firms evaluate a full set of state-contingent paths along which the economy might evolve out to a finite horizon but have limited ability to process events beyond that horizon. We show–analytically and empirically–that such a model accounts for an initial underreaction and subsequent overreaction of inflation forecasts. A planning horizon of four quarters can account for the evidence on the predictability of inflation forecast errors and macroeconomic data. Our identification and estimation strategies combine full-information methods based on aggregate data with regression-based estimates that directly use inflation expectations data.
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