Prospect theory and sentiment-driven fluctuations
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.