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. 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.
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