Solving Models with Disappointment Aversion

Abstract

We solve a dynamic general equilibrium model with generalized disappointment aversion preferences and continuous state endowment dynamics. We apply the framework to the term structure of interest rates and show that the model generates an upward sloping term structure of nominal interest rates, a downward sloping term structure of real interest rates, and that it accounts for the failure of the expectations hypothesis. The key ingredients are disappointment aversion preferences, preference for early resolution of uncertainty, and a parsimonious endowment economy with three state variables: time-varying macroeconomic uncertainty, time-varying expected inflation and inflation uncertainty.