Expectation Formation in a New Environment: Evidence from the German Reunification

Exploiting the German reunification, we study how households adapt to a new environment in their macroeconomic forecasting. East Germans expect higher inflation than West Germans decades after reunification. These differences are likely driven by the persistent effect of the inflation shock after reunification, which contrasted strongly with experiences of zero inflation in the GDR. East Germans' higher inflation expectations are reflected in higher consumer debt and lower bond holdings. Our findings suggest that large changes in the environment can permanently impede people's ability to form expectations, with an important role for the interaction of experiences before and after the event.