We introduce some elements of Prospect Theory into a general equilibrium model with monopolistic competition and real wage rigidities due to wage bargaining, or efficiency wages. We show that an increase in workers’ loss aversion: (i) reduces the equilibrium wage and in this way increases potential output; (ii) induces workers to work/ consume less and in this way decreases potential output. Sharper loss aversion may hence increase or decrease potential output according to the relative strength of these two effects. We also show that if loss aversion reduces equilibrium output, it also enhances the effect of nominal price rigidities.

Macroeconomic equilibrium and nominal price rigidities under imperfect rationality

CICCARONE, GIUSEPPE;Marchetti, Enrico
2019

Abstract

We introduce some elements of Prospect Theory into a general equilibrium model with monopolistic competition and real wage rigidities due to wage bargaining, or efficiency wages. We show that an increase in workers’ loss aversion: (i) reduces the equilibrium wage and in this way increases potential output; (ii) induces workers to work/ consume less and in this way decreases potential output. Sharper loss aversion may hence increase or decrease potential output according to the relative strength of these two effects. We also show that if loss aversion reduces equilibrium output, it also enhances the effect of nominal price rigidities.
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11367/72921
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