Standard real business cycle theory predicts that consumption should be smoother than output. Agents focus on permanent rather than temporary income when making decisions, so they react to an increase in income by saving part of it for future consumption. This prediction holds for developed countries, where the volatility of consumption is in general smaller than the volatility of output. In emerging economies however consumption is more volatile than income (23% at annual frequencies and 40% at quarterly frequencies), a phenomenon known as the Consumption Volatility Puzzle. In this paper we explore whether the introduction of political frictions into a standard real business cycle model can qualitatively and quantitatively explain this puzzle.
Financial institutions exist to improve the efficiency of the financial markets. If savers and investors, buyers and sellers, could locate each other efficiently, purchase any and all assets costlessly, and make their decisions with freely available perfect information, then financial institutions would have little scope for replacing or mediating direct transactions. However, this is not the real world.
Disappointment at doing worse than expected can be a powerful emotion. This emotion may be particularly intense when the disappointed agent exerted effort in competing for a prize, thus raising her expectation of winning. Furthermore, a rational agent who anticipates possible disappointment will optimize taking into account the expected disappointment arising from her choice.
