Mood, Memory, and Biased Beliefs and Decisions

Abstract

I first provide a static model of associative memory, a mnemonic process wherein cues in the environment bias information recalled from memory. I apply the model in a principal-agent setting to analyze contradictory predictions for the relationship between employee morale and productivity from the organizational behavior literature. I then develop a dynamic model that incorporates rehearsal and a model of mood dynamics. Applied in an asset pricing setting, the theory provides explanations for short-run continued overreaction to news, long-run correction of the overreaction, and excess price volatility. The model predicts that these effects are stronger for more volatile assets.