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Track M8-5: Disagreement, beliefs and asset prices
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Monetary Policy, Extrapolation Bias, and Misallocation University of Illinois Urbana-Champaign This paper studies the distributional effects of earning extrapolation bias on monetary transmission. Empirically, over-pessimistic firms with lower earning forecasts have higher investment elasticity to monetary shocks, which is more pronounced in the advertising-intensive industries. I develop a dynamic model to quantify the effects of extrapolation bias in a frictional product market, where firms extrapolate over idiosyncratic productivity news when making decisions on physical investment and customer acquisition. The model implies that firm-level overreaction amplifies the allocative efficiency of monetary easing: it raises aggregate productivity as capital flows to high markup firms. Moreover, the rise in aggregate output is underestimated by 57% if we assume rational expectation.
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