Working Paper: CEPR ID: DP5909
Authors: Nir Jaimovich; Sergio Rebelo
Abstract: 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.
Keywords: business cycles; expectations; optimism; overconfidence
JEL Codes: E3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| overconfidence (G41) | business cycle volatility (E32) |
| expectation shocks (D84) | business cycle volatility (E32) |
| overconfidence (G41) | overinvestment during economic booms (E22) |
| overconfidence (G41) | underinvestment during recessions (E22) |
| overconfidence (G41) | overall volatility (C58) |
| optimism (D84) | steady-state levels (D50) |
| autonomous shocks to expectations (D84) | business cycle volatility (E32) |