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Working Paper
Incorporating Diagnostic Expectations into the New Keynesian Framework
Diagnostic expectations constitute a realistic behavioral model of inference. This paper shows that this approach to expectation formation can be productively integrated into the New Keynesian framework. Diagnostic expectations generate endogenous extrapolation in general equilibrium. We show that diagnostic expectations generate extra amplification in the presence of nominal frictions; a fall in aggregate supply generates a Keynesian recession; fiscal policy is more effective at stimulating the economy. We perform Bayesian estimation of a rich medium-scale model that incorporates consensus ...
Working Paper
A Behavioral Foundation for the Investment Wedge
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 ...