Household Expectations: From Neuroscience to Household Finance and Macroeconomics.

• Author: Kuhnen, Camelia M.

Recent work in neuroscience and neuroeconomics has provided valuable insights into the factors that drive individuals' formation of expectations. These insights can be used by economists to better understand individuals' beliefs and behaviors. Moreover, aggregate-level implications can be drawn from these micro-level findings.

Neuroscientist Brian Knutson and I documented an asymmetry in the brain in the processing of gain and loss information. (1) This discovery of asymmetric encoding of positive and negative outcomes led to a hypothesis that could be tested experimentally in the context of financial decision-making. In experiments conducted in three countries--the United States, Romania, and Germany--I have found that learning occurs differently depending on whether gain or loss has taken place. Specifically, negative outcomes induce overly pessimistic beliefs about investment payoffs. (2) This is because, in an environment characterized by negative payoffs, people put too much weight on each additional bit of bad news. This experimental finding suggests that, at the aggregate level, recessions could last longer and be more severe than predicted by standard models, in part because of undue pessimism among individuals.

Participants in my experiments were temporarily exposed to environments characterized by only positive or only negative payoffs; they exhibited a clear bias toward pessimism in learning in the loss domain. Outside of the laboratory, however, many people have encountered negative outcomes on a regular basis, experiencing significant adversity. Do they process information about economic outcomes differently than others in the same age cohort, with the same macroeconomic history? Neuroscience suggests that to be the case. Specifically, it has been shown that experiencing adversity shapes the way the brain learns, so that there is an increased neural sensitivity to loss information and a decreased neural sensitivity to gain information. (3) In recent research, Sreyoshi Das, Stefan Nagel, Andrei Miu, and I find in laboratory experiments as well as in large survey data that people who have encountered more adversity, measured by socioeconomic status (SES), form more pessimistic beliefs about financial investments and economic opportunities and avoid investing in stocks or real estate. Controlling for participants' prior beliefs and the information they possess regarding investment options, Miu and I find that lower-SES individuals update less from high asset payoffs than their higher-SES counterparts, and end up with more pessimistic beliefs about the quality of these assets. As a result, lower-SES individuals are less likely to invest in these assets, particularly at times when, objectively, the assets can be expected to have high...