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Market Psychology, Animal Spirits and Reflexivity

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Neoclassical economics has abolished the role of psychology in decision making by assuming that all individuals are rational optimizers with rational expectations about future events.

Even if one allows psychology and emotions to affect individual behavior, what is the aggregate effect of idiosyncratic individual psychological shocks to the economy? Neo- classical economics assumes that at the aggregate level all idiosyncratic shocks wash out and that individuals on average behave rationally. This view has, for example, already been expressed in Muth (1961; p321) seminal paper introducing rational expectations [emphasis added]:

Allowing for cross-sectional differences in expectations is a simple matter, because their aggregate affect is negligible as long as the deviation from the rational forecast for an individual firm is not strongly correlated with those of the others. Modifications are necessary only if the correlation of the errors is large · · ·