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Rank-Dependent Probability Weighting And The Macroeconomy: Insights From A Model With Incomplete Markets And Aggregate Shocks

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Abstract

A vast experimental literature in both psychology and economics documents that individuals exhibit rankdependent probability weighting in economic decisions characterized by risk. I incorporate this well-known behavioral bias in a Rank-Dependent Expected Utility (RDEU) macroeconomic model. I develop a dynamic general equilibrium model with heterogeneous agents, labor market risk, and aggregate fluctuations, featuring households that are RDEU maximizers in an environment characterized by realistic labor market dynamics. I use the model to quantify the importance of RDEU for a number of macroeconomic outcomes. In a calibration of the model based on U.S. data, I find that RDEU plays an important role for the amount of aggregate wealth. Compared to the complete-markets EU benchmark, the long-run average of the capital stock rises by up to 12.6%. This large change is determined by the increased importance of precautionary saving, driven by the volatile labor market dynamics combined with the employed workers' pessimism. As for the outcomes routinely studied in the analysis of business-cycles, such as the volatility of both consumption and investment (relative to income), I find that RDEU improves the fit of the model. Overall, in terms of the discrepancy between model-generated business-cycle statistics and data, the RDEU models attain lower root mean squared errors than the EU one.

Suggested Citation

  • Marco Cozzi, 2024. "Rank-Dependent Probability Weighting And The Macroeconomy: Insights From A Model With Incomplete Markets And Aggregate Shocks," Department Discussion Papers 2402, Department of Economics, University of Victoria, revised Mar 2025.
    • Handle: RePEc:vic:vicddp:2402
    Note: ISSN 1914-2838
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    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D15 - Microeconomics - - Household Behavior - - - Intertemporal Household Choice; Life Cycle Models and Saving
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D90 - Microeconomics - - Micro-Based Behavioral Economics - - - General
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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