Working Paper Revision

Earnings Misperceptions and Household Distress

Abstract: Households learn whether income changes are temporary or persistent from their own paychecks. This paper develops a quantitative model of financial distress that incorporates this inference and estimates the extent to which households overweight recent outcomes—diagnostic expectations—using survey data on income beliefs. The model explains distress without assuming extreme impatience and aligns with the observed relationship between income and interest rates. Learning and diagnostic expectations account for about half of delinquencies and one-third of bankruptcies. Diagnostic expectations generate welfare losses equivalent to a 0.6% permanent reduction in consumption. A policy that limits large borrowing and saving among young households directly mitigates the behavioral distortion behind these losses, resulting in welfare gains of 0.12% of permanent consumption.

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: 2025-11-03

Number: 2025-030

Related Works

• Working Paper Revision (2025-11-12) : Earnings Misperceptions and Household Distress
• Working Paper Revision (2025-11-03) : You are here.
• Working Paper Original (2025-10-24) : Earnings Misperceptions and Household Distress