Behavioral Economics and Macroeconomic Models H/T Barry Ritholtz

John C. Driscoll*

Federal Reserve Board

and

Steinar Holden**

Department of Economics, University of Oslo

Forthcoming, Journal of Macroeconomics

Abstract

Over the past 20 years, macroeconomists have incorporated more and more results from behavioral economics into their models. We argue that doing so has helped fixed deficiencies with standard approaches to modeling the economy—for example, the counterfactual absence of inertia in the standard New Keynesian model of economic fluctuations. We survey efforts to use behavioral economics to improve some of the underpinnings of the New Keynesian model—specifically, consumption, the formation of expectations and determination of wages and employment that underlie aggregate supply, and the possibility of multiple equilibria and asset price bubbles. We also discuss more broadly the advantages and disadvantages of using behavioral economics features in macroeconomic models.

Behavioral Economics – Introduction

Over the past 20 years, researchers have incorporated an increasing number of results from behavioral economics into macroeconomic models. There are two main reasons for this change. First, it has become clear to macroeconomists that models based on assumptions of optimizing behavior in many cases have difficulty accounting for key real-world observations. Hence researchers have used behavioral economics assumptions with the aim of making their model predictions better fit the data. Early attempts to do this were criticized as being ad hoc. The force of this criticism has been reduced by the second reason for incorporating behavioral economics results into macroeconomics: cognitive psychologists and experimental economists have documented a number of systematic deviations between the decisions of human beings and those of the “economic man.”

The economics profession has widely, though by no means universally, acknowledged the empirical support for puzzles that can be explained by behavioral features. Moreover, behavioral features have been introduced in many parts of macroeconomics. Where have these development led us? Which assumptions should one now make when analyzing macroeconomic questions? The aim of this paper is to provide a selective survey of the implications of insights from behavioral economics for macroeconomic models. We argue that the insights from behavioral economics have led to important progress in our understanding of macroeconomic phenomena by allowing us to explain more aspects of real world behavior than we could with the more restrictive theoretical framework that most economists have been using. Some behavioral assumptions that have already been implemented in macroeconomic models, such as fairness considerations, seem especially promising to us. In other cases, we suspect that behavioral assumptions are needed for explaining macroeconomic puzzles—such as the inertial response of the economy to shocks – but are uncertain which assumptions are the best one. There are still other results from cognitive psychology whose macroeconomic implications have not been explored.

Incorporating behavioral assumptions into macroeconomic models is not without its problems. Even if there is considerable microeconomic evidence from cognitive psychology or experimental economics for certain behavioral features, it is often difficult to know which features are most relevant for macroeconomic models. For example, while there is strong evidence for inertia in macroeconomic consumption behavior, it is less clear whether this inertia should be viewed as the outcome of habit formation, rule-of-thumb consumption, or other alternatives. Another open issue is whether macroeconomic models should incorporate behavioral features or other deviations from the standard economic model, like financial frictions, limited information or agency problems. Thus, there is a need for more research to guide the choice of model specification.

Given the widespread impact of behavioral economics on macroeconomics, it has been necessary to narrow the discussion somewhat. We focus on economic fluctuations, unemployment and saving, as these are all core macro areas which have incorporated results from behavioral economics heavily.

 

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201443 Pap