Rational expectations and loss aversion: Potential output and welfare implications

Giuseppe Ciccarone and Enrico Marchetti

Journal of Economic Behavior & Organization, 2013, vol. 86, issue C, 24-36

Abstract: We add some elements of prospect theory to an analytically tractable version of Lucas's “islands” model and show that the inclusion of reference dependence, declining sensitivity and loss aversion into the agents’ utility function leads to four main results. First, the presence of behavioral elements negatively affects the natural level of output. Second, loss aversion reduces output variance. Third, the expected utility of a representative agent is generally lower than that obtained when loss aversion is absent. Fourth, the presence of loss aversion eliminates the paradoxical increase in expected utility that may be generated, in the standard model, by an increase in monetary policy uncertainty.

Keywords: Prospect theory; Behavioral economics; Signal extraction (search for similar items in EconPapers)
JEL-codes: D81 E32 E52 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jeborg:v:86:y:2013:i:c:p:24-36

DOI: 10.1016/j.jebo.2012.12.032

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