Can Unrealistic Optimism Among Consumers Precipitate Economic Recessions?

Abstract

This paper examines the macroeconomic implications of unrealistic optimism, a psychological bias that has been largely overlooked in economic models. While traditional models often link optimism to speculative bubbles and excessive risk taking, this study challenges that view by demonstrating that unrealistic optimism may rather accelerate recessions. Specifically, we develop a model in which consumers, under the influence of unrealistic optimism, believe that negative aggregate shocks will affect others but not themselves. This misjudgment leads to a premature fall in output prices, reducing production and triggering recessions. Additionally, we show that government intervention, when optimally timed, can mitigate the adverse effects of unrealistic optimism, offering important policy implications for stabilizing economies. By highlighting the possibility of optimism-induced downturns, this paper provides new insights into behavioral macroeconomics and offers a novel perspective on policy design.