Abstract This paper incorporates diagnostic expectations into a general equilibrium macroeconomic model with a financial intermediary sector. Diagnostic expectations are a forward-looking model of extrapolative expectations that overreact to recent news. Frictions in financial intermediation produce non-linear spikes in risk premia and slumps in investment during periods of financial distress. The interaction of sentiment with financial frictions generates a short-run amplification effect followed by a long-run reversal effect, termed the feedback from behavioural 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 sentiment 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.

Abstract By augmenting the continuous-time specification of Harris and Laibson (2013) with the assumption that hard borrowing constraints do not bind in equilibrium, present bias can be tractably incorporated into rich consumption-saving models featuring stochastic income, risky and illiquid assets, and costly borrowing. I present closed-form expressions characterizing how present bias affects consumption, illiquid asset demand, and welfare. This welfare analysis specifies the channels through which present bias can matter for policy and uncovers the present-bias dilemma: present bias can have large welfare costs, but individuals have little ability to alleviate these costs using financial commitment devices like illiquid assets.

Abstract We study the effect of monetary and fiscal policy in a heterogeneous-agent model where households have present-biased time preferences and naive beliefs. 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 effect 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. Present bias also introduces a motive for households to procrastinate refinancing their mortgages, which slows down the speed with which this monetary channel operates.

Abstract We estimate β-δ time preferences and relative risk aversion (RRA) using a lifecycle model including stochastic income, liquid and illiquid assets, credit cards, dependents, Social Security, mortality, and bequests. Preference parameters are identified by cross-tabulating four lifecycle age intervals and four balance sheet moments: the share of households carrying (ie, revolving) credit card debt, average carried credit card debt, average net wealth among households carrying credit card debt, and average net wealth among households not carrying credit card debt. The 16 moments are approximately matched by (MSM) parameter estimates β=0.53, δ=0.99, and RRA = 1.9.