A Behavioral Foundation for the Investment Wedge

Jean-Paul L’Huillier, Pierlauro Lopez and Sanjay R. Singh
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Jean-Paul L’Huillier: https://www.clevelandfed.org/people/profiles/l/lhuillier-jean-paul

No 2025-22, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: Motivated by behavioral evidence, we develop a tractable method for incorporating competition neglect in a general equilibrium firm investment problem. Competition neglect causes firms to systematically underestimate the investment of their competitors. When we introduce competition neglect into a canonical RBC model, this friction acts like an investment wedge that causes overinvestment at first, and underinvestment later on. In contrast to a model with exogenous investment shocks, these dynamics are accompanied by realistic variation in equity premia, even in the absence of financial frictions. Investment booms raise stock prices in general equilibrium, predicting periods of low excess returns going forward. The model can generate realistic comovement of real and financial variables.

Keywords: animal spirits; boom-bust cycles; Behavioral macroeconomics (search for similar items in EconPapers)
JEL-codes: D21 D91 E22 E32 (search for similar items in EconPapers)
Pages: 39
Date: 2025-10-08
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfwp:101905

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DOI: 10.24148/wp2025-22

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