A Behavioral Business Cycle Model : A Unified Framework Using Prospect Theory

Empirical and experimental findings in the literature indicate that the motives for saving, consumers’ anger, and employees’ morale affect economic decision-making. Prospect theory is used to incorporate these factors into a business cycle model. Nominal rigidity endogenously arises and the model replicates the Phillips curve strikingly well. A simple diagrammatic analysis clarifies the mechanism of the Phillips curve. The model reconciles controversies surrounding macroeconomics: missing deflation during the 2008 financial crisis, missing inflation after the crisis, empirical failure of the Euler equation, and the effects of fiscal policy. Thus, the unified framework is a viable approach to business cycle research