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Imperfect rationality, macroeconomic equilibrium and price rigidities

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  • Giuseppe Ciccarone
  • Francesco Giuli

Abstract

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.

Suggested Citation

  • Giuseppe Ciccarone & Francesco Giuli, 2013. "Imperfect rationality, macroeconomic equilibrium and price rigidities," Departmental Working Papers of Economics - University 'Roma Tre' 0183, Department of Economics - University Roma Tre.
  • Handle: RePEc:rtr:wpaper:0183
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    More about this item

    Keywords

    Macroeconomic equilibrium; Prospect theory; Behavioral economics;
    All these keywords.

    JEL classification:

    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles

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