Macroeconomic effects of loss aversion in a signal extraction model

We add some elements of prospect theory to an analytically tractable version of Lucas’s “islands” model and show that the inclusion of reference dependence, declining sensitivity and loss aversion into the agents’ utility function leads to three main results. First, the equilibrium labor supply and the natural level of output are negatively affected by the presence of behavioral elements, whereas the cyclical response of output to a monetary shock remains unaltered. Second, the expected utility of a representative agent is generally lower than that obtained when loss aversion is absent. Third, the presence of loss aversion eliminates the paradoxical increase in expected utility that may be generated, in the standard model, by an increase in monetary policy uncertainty