Behavioral Foundations for Macroeconomics: Prospect Theory in Heterogeneous Agent Models

Abstract

Taking inspiration from the Lucas Critique's call to microfoundations (Lucas 1976), I model an economy of heterogeneous agents who have prospect theory preferences (Kahnemann and Tversky, 1979) as a kind of more behaviorally based microfoun- dations. The basics of the model come from Aiyagari's model of an economy with uninsured idiosyncratic risk (1994), with adaptations made for prospect theory prefer- ences. Equilibrium and cross-sectional results are computed, and I nd lower interest rates and a signi cantly higher capital stock due to a stronger precautionary motive and the introduction of a habit-formation motive.