Answering the hardest question in economics – marrying behavioral to rational thinking..

Noah Smith isn’t just pointing to evidence that debunks old ideas but also to new ideas which could help macro gain some credibility.

In his recent post, he points to new papers which could shape macro in future:

Xavier Gabaix, a New York University economist who gets far less attention than he should, has written what might prove to be the most interesting macroeconomic theory paper in years. The title, “A Behavioral New Keynesian Model,” isn’t exactly exciting and the paper is still incomplete, but it might help resolve the most important and difficult macroeconomic debate in academia today — whether low interest rates cause inflation, deflation or neither. And it might signal a sea change in the way macroeconomic theory gets done.

Traditionally, macroeconomists have believed that low interest rates encourage inflation. But first Japan, and now the U.S. and Europe have kept rates low for years now, and inflation has stayed stubbornly low. A radical group of macroeconomists, including Stephen Williamson of the Federal Reserve Bank of St. Louis and John Cochrane of the Hoover Institution, have introduced a new theory called Neo-Fisherism, which says that a long period of low interest rates actually holds prices down instead of pushing them up. Williamson and Cochrane have both repeatedly stressed that New Keynesian models — the most mainstream type of macroeconomic theory — can easily yield the Neo-Fisherian result instead of the traditional view. One problem is that the standard models are often ambiguous — they offer a number of possible, radically different outcomes for the economy, with no way to tell which will happen.

Gabaix tackles these problems with a simple, intuitive, yet bold step. Instead of assuming that people are perfectly rational, he theorizes that they have limited attention — what psychologist Herbert Simon called “bounded rationality.” When interest rates or gross domestic product change, people in Gabaix’s model don’t quite realize that things are different. Even more importantly, they’re short-sighted — they don’t think as much about the probability of a recession happening 10 years from now as they do about one occurring in the next six months.

Those ideas probably seem obvious to most people. When events are further in the future, you worry about them less, right? I know I do. But to macroeconomists, this is a pretty radical step. Most macroeconomic researchers are strict adherents to the cult of perfect rationality. If the economy looks like it’s being driven by behavior that isn’t quite rational, macroeconomists usually bend over backward to explain it as a failure of economic institutions, rather than a result of human psychology.

Wonder what took it so long. It was just waiting to happen.

His paper shows following outcomes:

  1. Fiscal policy is much more powerful than in the traditional model:1 in the traditional model, rational agents are Ricardian and do not react to tax cuts. In the behavioral model, agents are partly myopic, and consume more when they receive tax cuts. As a result, we can study the interaction between monetary and fiscal policy.
  2. The zero lower bound (ZLB) is much less costly.
  3. The model can explain the surprising stability in economies stuck at the ZLB, something that is difficult to achieve in traditional models.
  4. Equilibrium selection issues vanish in many cases: for instance, even with a constant nominal interest rate there is just one (bounded) equilibrium.
  5.  Forward guidance is much less powerful than in the traditional model, offering a natural behavioral resolution of the “forward guidance puzzle”.
  6. A number of neo-Fisherian paradoxes are resolved. A permanent rise in the nominal interest rate causes inflation to fall in the short run (a Keynesian effect), and rise in the long run (so that the long-run Fisher neutrality holds with respect to inflation).

Will be interesting to see what direction does all this take. Though, a glance at the paper shows no behavior, it is just equations..

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