Ricerc@Sapienza

In this paper we aim to present a novel channel through which the volatility of the monetary/financial sector affects the instability of the real macroeconomic variables originated by self-fulfilling market sentiments. To this aim, we insert some elements of Prospect Theory in the preferences of agents living in an overlapping generations economy where consumers’heterogeneity and firms’imperfect information on the level of aggregate demand allow market sentiments to affect the equilibrium path of the economy under rational expectations.

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