PROSPECT THEORY AND SELF-FULFILLING MARKET SENTIMENTS

Giuseppe Ciccarone, Francesco Giuli and Enrico Marchetti

No 216, Departmental Working Papers of Economics - University 'Roma Tre' from Department of Economics - University Roma Tre

Abstract: In this paper we present a novel channel through which the volatility of the monetary/financial sector affects the instability of the real macroeconomic variables originated by self-fulfilling market sentiments. To this aim, we insert some elements of Prospect Theory in the preferences of agents living in an overlapping generations economy where consumers’ heterogeneity and firms’ imperfect information on the level of aggregate demand allow market sentiments to affect the equilibrium path of the economy. In this environment, greater heterogeneity in the household’s narrow framing parameter favour the emergence of self-fulfilling equilibria by exacerbating the coordination problem generated by a pair-wise matching process in the labor market. Furthermore, higher volatility of the money market, by increasing the effect of Prospect Theory on households’ choices, makes the signal upon which firms form their demand schedules noisier; this, in its turn, generates greater variability in market sentiments and hence in real economic activity.

Keywords: Prospect theory; Self-fulfilling equilibria; Sentiments; Behavioral macroeconomics. (search for similar items in EconPapers)
JEL-codes: D84 E03 E32 (search for similar items in EconPapers)
Pages: 31
Date: 2017-03
New Economics Papers: this item is included in nep-dge, nep-mac and nep-upt
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