DP5909 Behavioural Theories of the Business Cycle

Author(s): Nir Jaimovich, Sérgio Rebelo
Publication Date: October 2006
Keyword(s): business cycles, expectations, optimism, overconfidence
JEL(s): E3
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5909

We explore the business cycle implications of expectation shocks and of two well-known psychological biases, optimism and overconfidence. The expectations of optimistic agents are biased toward good outcomes, while overconfident agents overestimate the precision of the signals that they receive. Both expectation shocks and overconfidence can increase business-cycle volatility, while preserving the model's properties in terms of comovement, and relative volatilities. In contrast, optimism is not a useful source of volatility in our model.