Credit market frictions and rational agents' myopia: Modeling financial frictions and shock to expectations in a DSGE setting estimated on Slovenian data

Roccazzella, Francesco [UCL]

Agents’ beliefs and their confidence about the current and prospective economic conjecture are relevant drivers of the Slovenian business cycle. Loss aversion, ambiguity aversion and bounded rationality are the theoretical basement of the model, while shocks to the real discount factor, to the intertemporal elasticity of consumptions and to the myopic factor for firms are the theoretical tools used to implement shifts of confidence for households and capital assets producers in DSGE modeling. We have realistically assumed that households are myopic so they ignore (or they do not perfectly consider) that the economy is endogenously returning to the equilibrium after a positive or negative business phase in the long run. Hence, they perceive a deviation from the steady state as a permanent structural change and so, while a positive shock will increase their enthusiasm and their propensity to invest and to consume, a negative event induces fear, feeding uncertainty and boosting the bent to save. The estimated impulse responses confirm that both households’ and capital assets producers’ myopic shock, as well the shock to the intertemporal elasticity of substitution in consumption, have statistically significant and important effects on the economy. We implement the financial accelerator set up to consider credit-market frictions, introducing another source of potential instability in the model. Furthermore, we impose that the financial requirements necessary to access the credit market behave procyclically too, extending the original financial accelerator proposed by Bernanke et al. (1999). Focusing on agents’ perception of the policy is the main implication of the research: communication and signaling are powerful and crucial tools for monetary authorities. After having dissected the business cycle of Slovenia, it is clear that not-fully rational agents, in an economy of self-fulfilling expectations, may neutralize or even overturn the initial goal of policy-makers producing unexpected and protracted consequences, especially when confidence is weak or the perception of the new policy action is distorted.