Understanding expectations formation for hand‐to‐mouth households: lessons from the financial crisis

Abstract We study how poor hand‐to‐mouth and wealthy hand‐to‐mouth households in the United States form their expectations as compared to unconstrained households. To do so, we use monthly household data for the period 2005:2 to 2013:6 with information on the exact survey day for each household within a month. Utilizing a timeline of financial crisis events along with changes in stock market values and uncertainty in the days around those events, we assess the response of these households' expectations regarding inflation, unemployment, and the interest rate. Our estimates imply differences in the formation of expectations for liquidity‐constrained households relative to unconstrained households. Wealthy hand‐to‐mouth households tend to revise their inflation expectations downwards substantially so that they make lower forecast errors following adverse financial crisis events that lower the actual future inflation rate, while other households appear inattentive to these shocks. This suggests that the wealthy hand‐to‐mouth households decipher these financial events' noisy signal regarding lower future inflation more accurately than other households, in line with having a greater incentive to do so.