Expectation Formation and Firm Activities: New evidence from a business outlook survey in Japan

This paper uses the Japanese Business Outlook Survey to examine the role of expectations in shaping business investment and hiring plans. We combine qualitative assessments of both macro- and micro-level business conditions and information of firm-level outcomes such as sales and investment. We then document five new facts concerning firm expectations. First, forecasts made earlier are less precise and more optimistic. Second, forecasted sales are less volatile than realized sales adjusted based on realized sales in the past. Third, volatility of firms' sales growth and variance of their forecast errors co-move over the business cycles. Fourth, firms' forecasts of micro- and macro-level business conditions are positively correlated with their investment and hiring plans. Firms' assessments about micro-level business conditions have larger impacts on their investment and hiring plans than their assessments about macro-level business conditions, and these results are more pervasive among smaller firms. Finally, firms' investment and hiring plans are positively correlated with past sales growth. In particular, if such sales growth is higher than the forecast, firms adjust their investment and hiring plans upward. These results suggest both an extrapolative and forward-looking structure of business outlook and plans.