Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy?

Raman Uppal and Harjoat Bhamra

No 1358, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: A common criticism of behavioral economics is that it has not shown that individual investors' biases lead to aggregate long-run effects on both asset prices and macroeconomic quantities. Our objective is to address this criticism in a production economy where individual portfolio biases cancel when summed across investors, but still have an effect on aggregate quantities in the long-run. We solve in closed form a model of a stochastic general-equilibrium production economy with a large number of heterogeneous firms and investors. Investors are ambiguity averse, so they hold portfolios biased toward familiar assets. We specify this bias to be unsystematic - it cancels out when aggregated across investors. However, each investor bears more risk than necessary, which distorts the consumption of all investors in the same direction. Hence, distortions in consumption do not cancel out in aggregate and increasing the price of risk and distorting aggregate investment and growth. The increased risk from holding biased portfolios, which increases the demand for the risk-free asset, leading to a higher equity risk premium and lower risk-free rate that match empirical values. Our analysis illustrates that idiosyncratic behavioral biases can have long-run distortionary effects on both financial markets and the macroeconomy

Date: 2016
New Economics Papers: this item is included in nep-dge, nep-ifn, nep-mac and nep-upt
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Working Paper: Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy? (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:1358

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