Monetary Sunspots, Preference Discovery Costs, and the Equity Premium

This dissertation investigates whether criticisms of standard economic models can be addressed with only minimal modifications to the assumptions. In the first essay, the Real Business Cycle (RBC) model is studied, though it is well known that it cannot match the data on money. My solution is to retain the RBC framework but add money as a sunspot variable. This leaves all the main elements of the RBC model intact and successfully replicates many features of the monetary data. The second essay examines rational choice, the foundation of economics. Laboratory experiments have exposed small violations of the theory. I introduce preference discovery costs as a way to accommodate minor violations of revealed preference while retaining rationality and optimization. An experiment tested my idea. For several subjects, my model explained their behavior while standard theory could not. However, there were many other subjects whose behavior was incompatible with both theories. The last essay is about the equity premium puzzle. The standard framework in macroeconomics predicts that the equity premium will be quite small, but this prediction is off by an order of magnitude. However, I demonstrate that the problem can be resolved if there is no market for insurance against idiosyncratic income shocks. Though it is very realistic to relax the complete markets assumption and this suffices to solve the puzzle, it is debatable if this modification is truly minimal, given the prevalence of models that rely on market completeness.10000-01-0