Expectation formation and regime switches

Economic agents often have to make decisions in environments affected by regime switches but expectation formation has hardly been explored in this context. We report about a laboratory experiment whose participants judgmentally forecast three time series subject to regime switches. The participants make forecasts without context knowledge and without support from statistical software. Their forecasts are only based on the previous realizations of the time series. Our interest is the explanation of the average forecasts with a simple model, the bounds & likelihood heuristic. In previous studies it was shown that this model can explain average forecasting behavior very well given stable and stationary time series. We find that the forecasts after a structural break are characterized by a higher variance and less accuracy over several periods. Considering this transition phase in the model, the heuristic performs even slightly better than the Rational Expectations Hypothesis.