Working Papers

This paper develops a theory of subjective beliefs that departs from rational expectations, and shows that biases in household beliefs have quantitatively large effects on macroeconomic aggregates. The departures are formalized using model-consistent notions of pessimism and optimism and are disciplined by data on household forecasts. The role of subjective beliefs is quantified in a business cycle model with goods and labor market frictions. Consistent with the survey evidence, an increase in pessimism generates upward biases in unemployment and inflation forecasts and lowers economic activity. The underlying belief distortions reduce aggregate demand and propagate through frictional goods and labor markets. As a by-product of the analysis, solution techniques that preserve the effects of time-varying belief distortions in the class of linear solutions are developed.