This paper presents new evidence on the expectation formation process from a Dutch household survey. Households become too optimistic about their future income after their income has improved, consistent with the overextrapolation of their experience. We show that this effect of experience is persistent and that households overextrapolate income losses more than income gains. Furthermore, older households overextrapolate more, suggesting that they did not learn over time to form more accurate expectations. Finally, we study the relationship between expectation errors and consumption. We find that more overoptimistic households intend to consume more and subsequently report higher consumption, even though they do not consume as much as they intended to. These results suggest that overextrapolation hurts consumers and amplifies business cycles.
Journal of Economic Behavior and Organization, Volume 164, pp. 77-90, 2019