Tail risk and expectations

This study examines how the beliefs of tail risk events influence macroeconomic expectations. By incorporating tail risk in a Bayesian learning model with noisy signals, we theoretically and empirically show that individuals overreact when faced with first and second moment shocks. First moment shocks result in excessive optimism and pessimism in individuals as they provide valuable information about tail risk. Second moment shocks lead to more pessimistic forecasts as higher uncertainty is linked to an increased likelihood of disasters. As signals becomes noisier, the response to news regarding a first moment shock becomes more pronounced. Our findings shed light on factors driving overreaction in expectations and highlight the importance of uncertainty shocks in propagating macroeconomic stability.