By Amedeo Argentiero, Maurizio Bovi and Roy Cerqueti
Standard dynamic stochastic general equilibrium (DSGE) models are populated by fully-informed-optimising Muth-rational agents. This kind of agent is at odds with well-known psychological biases, not to mention real life people. In particular, there are strong theoretical and empirical reasons to believe that consumers are overly optimistic. Also, the size of over optimism is likely to show cyclical features. In this paper we simulate two DSGE models, one standard with Muth-rational consumers, the other different just because agents are allowed to over consume. We then compare them throughout different cyclical phases. Results show that taking into account psychological biases allows the DSGE to fit better actual data in the long-run and in an economic boom scenario. Recessions are instead characterized by pessimism. We also find that over consumption is a structural trait. Moreover, booms enlarge significantly the magnitude of the bias. These findings are in line with – and enrich – both the economic and psychological literature, implying i) that the business cycle has a non trivial psychological content, and ii) that the size of psychological biases is affected by macroeconomic evolutions.
This is interesting, but I would be careful before stating that such psychological biases are of macroeconomic importance. Indeed, the exercise here is to estimate a standard RE model, then re-estimate it with a bias parameter. The latter may be capturing any other model miss-specification, and to be honest it is difficult to get a worse fit when you add a parameter. Also, the result could also be consistent with self-fulfilling expectation, which may not be observationally different, and the latter can assume perfectly rational and unbiased agents.
As a matter of fact, we do have an identification strategy.
Adding a psycho-bias as a separate fundamental we are close to the literature of self-fulfilling a là Farmer. Yet, our extra term is different from the generic “confidence” usually mentioned. In fact, we expect that the sign of our bias is structurally positive. Also we predict that the bias is even larger in booms but zero amid crises. These a priori are at odds with the self-fulfilling literature that, as far as we know, argues that confidence is crucial especially in economic turmoil. Lastly, evidence supports our setting.
Thank you for commenting our paper.
A. Argentero, M. Bovi and R. Cerqueti