Essays in Behavioral Macro-Finance

Abstract

This dissertation presents three chapters that study the effect of incorporating insights from behavioral economics into macro-finance models.

The first chapter evaluates the impact of diagnostic (extrapolative) expectations in a macroeconomic model with a financial intermediary sector. The interaction of extrapolative expectations with financial frictions generates a short-run amplification effect followed by a long-run reversal effect, termed the feedback from behavioral frictions to financial frictions. The model features sentiment-driven financial crises characterized by low pre-crisis risk premia and neglected risk. The conflicting short-run and long-run effect of expectations produces boom-bust investment cycles. The model also identifies a stabilizing role for diagnostic expectations. Under the baseline calibration, financial crises are less likely to occur when expectations are diagnostic than when they are rational.

The second chapter studies the effect of monetary and fiscal policy in a heterogeneous-agent model where households have present-biased time preferences. The model features a liquid asset and illiquid home equity, which households can use as collateral for borrowing. Because present bias substantially increases households’ marginal propensity to consume (MPC), present bias increases the impact of fiscal policy. Present bias also amplifies the effect of monetary policy but, at the same time, slows down the speed of monetary transmission. Interest rate cuts incentivize households to conduct cash-out refinances, which become targeted liquidity-injections to high-MPC households. But present bias also introduces a motive for households to procrastinate refinancing their mortgages, which slows down the speed with which this monetary channel operates.

The third chapter presents a theoretical analysis of the consumption-saving decisions of present-biased consumers. Building on Harris and Laibson (2012), I show that continuous-time methods allow for present bias to be tractably incorporated into incomplete markets models. First, I solve a workhorse Aiyagari-Bewley-Huggett model with present-biased consumers. The equilibrium with present bias features a larger mass of low-liquidity households and a higher aggregate marginal propensity to consume (MPC), but also a thicker right tail of high-wealth households. Second, I extend the model to include credit cards, illiquid assets, and naivete. In this rich economic environment I present closed-form expressions characterizing the effect of present bias on consumption, the demand for illiquid assets, and welfare. This welfare analysis specifies the channels through which present bias can matter for policy, and leads to what I call the present-bias dilemma: present bias has large welfare costs, but individuals have little ability to alleviate these costs without government intervention.