Working Paper
A Behavioral Foundation for the Investment Wedge
Abstract: Motivated by behavioral evidence, we develop a tractable method for incorporating competition neglect in a general equilibrium firm investment problem. Competition neglect causes firms to systematically underestimate the investment of their competitors. When we introduce competition neglect into a canonical RBC model, this friction acts like an investment wedge that causes overinvestment at first, and underinvestment later on. In contrast to a model with exogenous investment shocks, these dynamics are accompanied by realistic variation in equity premia, even in the absence of financial frictions. Investment booms raise stock prices in general equilibrium, predicting periods of low excess returns going forward. The model can generate realistic comovement of real and financial variables.
JEL Classification: E22; E32; D21; D91;
https://doi.org/10.24148/wp2025-22
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Bibliographic Information
Provider: Federal Reserve Bank of San Francisco
Part of Series: Working Paper Series
Publication Date: 2025-10-08
Number: 2025-22