Firm Expectations and News: Micro v Macro


Firm expectations reflect micro and macro news: information about firm-level developments and the aggregate economy. We formalize this notion in a stylized general-equilibrium model where firms face a signal-extraction problem and study the implications of `island illusion,’ meaning that firms systematically underestimate the importance of aggregate developments for their own performance. Island illusion is governed by a single parameter that captures the departure from rational expectations. It imposes joint restrictions on the impact of micro and macro news that we confront with survey data for Italian and German firms. While both surveys differ along many dimensions, we find robustly that firms’ expectations about their own prices and output overreact to micro news and underreact to macro news—just like the model predicts for island illusion. Moreover, also consistent with the model, we find the extent of overreaction and underreaction to co-move positively, both over time and across firms.