Working Paper

Earnings Misperceptions and Household Distress

Abstract: Households learn whether income changes are temporary or persistent from the history of their own paychecks. This paper develops a quantitative model of household financial distress that incorporates this inference and uses survey data on income expectations to estimate the extent to which households overweight recent outcomes—diagnostic expectations. The model improves on the standard full-information, rational-expectations benchmark in two key dimensions: it explains financial distress without assuming extreme impatience, and it more accurately captures the empirical correlation between income and interest rates. Learning and diagnostic expectations play a central role, accounting for roughly half of delinquencies and more than one-third of bankruptcies, and generating welfare losses equivalent to a 1.5 percent permanent decline in consumption. Policies designed to reduce financial distress are markedly more effective in the model with diagnostic expectations.

JEL Classification: D14; D84; E21; G51;

https://doi.org/10.20955/wp.2025.030

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2025-10-24

Number: 2025-030