Macroeconomic effects of loss aversion in a signal extraction model
AbstractWe add some elements of prospect theory to an analytically tractable version of Lucasâ€™s â€œislandsâ€ model and show that the inclusion of reference dependence, declining sensitivity and loss aversion into the agentsâ€™ utility function leads to three main results. First, the equilibrium labor supply and the natural level of output are negatively affected by the presence of behavioral elements, whereas the cyclical response of output to a monetary shock remains unaltered. Second, the expected utility of a representative agent is generally lower than that obtained when loss aversion is absent. Third, 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.
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Bibliographic InfoPaper provided by University of Rome La Sapienza, Department of Public Economics in its series Working Papers with number 148.
Date of creation: Oct 2011
Date of revision:
Prospect Theory; Behavioral economics; Signal extraction.;
Find related papers by JEL classification:
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-02-27 (All new papers)
- NEP-CBA-2012-02-27 (Central Banking)
- NEP-EVO-2012-02-27 (Evolutionary Economics)
- NEP-MAC-2012-02-27 (Macroeconomics)
- NEP-UPT-2012-02-27 (Utility Models & Prospect Theory)
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