Rational expectations and loss aversion: Potential output and welfare implications

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 four main results. First, the presence of behavioral elements negatively affects the natural level of output. Second, loss aversion reduces output variance. Third, the expected utility of a representative agent is generally lower than that obtained when loss aversion is absent. Fourth, 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.

► Some elements of prospect theory are added to Lucas's “islands” model.
► Behavioral elements negatively affect natural output.
► They also reduce output variance.
► Expected utility is lowered due to loss aversion.
► Paradoxical effects of monetary variance are eliminated by loss aversion.