Working Paper
Francesca Bastianello and Paul Fontanier. Working Paper. “Partial Equilibrium Thinking in General Equilibrium”.Abstract

We develop a theory of “Partial Equilibrium Thinking” (PET), whereby agents fail to understand the general equilibrium consequences of their actions when inferring information from endogenous outcomes. PET generates a two-way feedback effect between outcomes and beliefs, which can lead to arbitrarily large deviations from fundamentals. Our insights extend to general forms of model misspecification, and to heterogenous agents. In financial markets, PET equilibrium outcomes exhibit over-reaction, excess volatility, high trading volume, and return predictability. More sophisticated agents may contribute to greater departures from rationality. Misinference from assuming the world is rational amplifies biases in non-rational Bayesian updating.