Partial Equilibrium Thinking in General Equilibrium∗ Francesca Bastianello Paul Fontanier April 1, 2021 Abstract We develop a theory of “Partial Equilibrium Thinking” (PET), whereby agents fail to understand the general equilibrium consequences of their actions when infer- ring information from endogenous outcomes. PET generates a two-way feedback ef- fect between outcomes and beliefs, which can lead to arbitrarily large deviations from fundamentals. In financial markets, PET equilibrium outcomes exhibit over-reaction, excess volatility, high trading volume, and return predictability. We extend our model to allow for rationality of higher-order beliefs, general forms of model misspecification, and heterogenous agents. We show that more sophisticated agents may contribute to greater departures from rationality. We also draw a distinction between models of misinference and models with biases in Bayesian updating, and study how these two departures from rationality interact. Misinference from mistakenly assuming the world is rational amplifies biases in Bayesian updating. ∗Harvard University: francesca
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[email protected]. We thank Nicholas Barberis, John Campbell, Kent Daniel, Ester Faia, Emmanuel Farhi, Nicola Gennaioli, Thomas Graeber, Xavier Gabaix, Robin Greenwood, Sam Hanson, Oliver Hart, Ryota Iijima, David Laibson, Eben Lazarus, Ian Martin, Matthew Rabin, Josh Schwartzstein, Andrei Shleifer, Jeremy Stein, Tomasz Strzalecki, Adi Sunderam, Dimitri Vayanos, Luis Viceira, Jessica Wachter and seminar participants at the Harvard Finance Lunch, Harvard Theory and Behavioral Lunch, Harvard Contracts and Organizations Lunch, 10th Miami Behavioral Finance conference, and 12th World Congress of the Econometric Association for useful comments. Francesca Bastianello is grateful for support from the Alfred P. Sloan Foundation Pre-doctoral Fellowship in Behavioral Macroeconomics, awarded through the NBER.