'Base-rate Neglect in General Equilibrium'
Base-rate neglect is a tendency for people to ignore prior probabilities in favor of more salient sample information when making predictions. In this paper, I introduce base-rate neglect into an environment in which agents make sequential forecasts about recessions and booms, and study its consequences to the aggregate economy. When confronted with U.S. GDP growth data, agents worry too much about recessions and does not appreciate enough of the prospect of booms. In addition, the volatility of her estimates rises during recessions and drops during booms. In a general equilibrium model, this pessimism drives business cycles, leads to lower growth rates and excess volatility, and reduces welfare.