Heterogeneous Beliefs, Asset Prices, and Business Cycles

This paper develops a complete-market production economy with heterogeneous beliefs about TFP growth. Hiring occurs before TFP is known and is, therefore, risky (operational leverage). The firm's discount factor depends on a wealth-weighted average of investors' beliefs. Waves of optimism influence asset markets and percolate to labor hiring, tying together the equity premium, equity volatility, and labor volatility puzzles. A taxonomy of belief systems shows that only extrapolative beliefs amplify the volatility of asset prices and hours and lead to risk build up. Disciplined by survey data, the model matches asset-pricing and business-cycle moments, highlighting how heterogeneous beliefs can be a direct driver of aggregate fluctuations.