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Imperfect rationality, macroeconomic equilibrium and price rigidities

  • Giuseppe Ciccarone
  • Francesco Giuli

We introduce some elements of Prospect Theory into a general equilibrium model with monopolistic competition in the good market and real wage rigidities due to (right to manage or efficient) wage bargaining, or to efficiency wages. We show that, under these types of labor market frictions, an increase in workers’ loss aversion: (i) reduces the equilibrium wage and in this way increases potential output; (ii) induces workers to work and consume less and in this way decreases potential output. If the former effect is greater (smaller) than the latter one, loss aversion increases(decreases) potential output. We also show that, under all the types of labor market frictions we consider, if loss aversion reduces equilibrium output, it also enhances the plausibility of nominal price rigidities.

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Paper provided by Department of Economics - University Roma Tre in its series Departmental Working Papers of Economics - University 'Roma Tre' with number 0183.

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Date of creation: Sep 2013
Date of revision:
Handle: RePEc:rtr:wpaper:0183
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  1. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-20, September.
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  18. Matthew Rabin, 2013. "An Approach to Incorporating Psychology into Economics," American Economic Review, American Economic Association, vol. 103(3), pages 617-22, May.
  19. Ciccarone, Giuseppe & Marchetti, Enrico, 2013. "Rational expectations and loss aversion: Potential output and welfare implications," Journal of Economic Behavior & Organization, Elsevier, vol. 86(C), pages 24-36.
  20. Ball, Laurence & Romer, David, 1990. "Real Rigidities and the Non-neutrality of Money," Review of Economic Studies, Wiley Blackwell, vol. 57(2), pages 183-203, April.
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