Subjective Income Expectations and Household Debt Cycles

Matched transaction-level, credit-registry, and survey-based data reveal that consumers on average form excessively high (low) income expectations relative to ex-post realizations after unexpected positive (negative) income shocks. These extrapolative income expectations lead consumers to increase current spending, accumulate more debt, and face more defaults when lower-than-expected incomes are realized. We assess the aggregate implications by estimating a consumption model with defaultable unsecured debt and diagnostic Kalman filtering whereby consumers over-extrapolate income shocks when forming expectations. Extrapolative income expectations help explain state-dependent household debt cycles qualitatively and quantitatively.