BEHAVIORALMACROECONOMICS

PaulDeGrauwe

UniversityofLeuven























Febiuaiy 2u11

2
TableofContents




Intiouuction

Chaptei 1: The New Keynesian Nacioeconomic Nouel

Chaptei 2: The Scientific Founuation of the New Keynesian Nacioeconomic
Nouel

Chaptei S: A Behavioial Nacioeconomic Nouel

Chaptei 4: The Tiansmission of Shocks

Chaptei S: 0ptimal Nonetaiy Policy

Chaptei 6: Flexibility, Animal Spiiits anu Stabilization

Chaptei 7: Animal Spiiits anu the Natuie of Nacioeconomic Shocks

Chaptei 8: Stock Piices anu Nonetaiy Policy

Chaptei 9: Extensions of the Basic Nouel

Chaptei 1u: Empiiical Issues

Conclusion
S
Introduction

0ntil the eiuption of the financial ciisis in 2uu7 it lookeu as if macioeconomics
hau achieveu the pinnacle of scientific success. The inuustiial woilu expeiienceu
a time of gieat macioeconomic stability with low anu stable inflation, high anu
sustaineu economic giowth, anu low volatility of many economic anu financial
vaiiables. Economists weie uebating the causes of this uieat Noueiation anu
theie was a geneial consensus that at least pait of it was uue to the new
scientific insights pioviueu by mouein macioeconomic theoiy. This theoiy
embouieu the iational agent, who continuously optimizes his utility using all
available infoimation. In this woilu weie inuiviuual agents make no systematic
mistakes, stability ieigns. Suie theie was a iecognition that macioeconomic
vaiiables coulu be subjecteu to laige changes, but these changes always founu
theii souice outsiue the woilu of these iational agents. If left alone the lattei,
with the help of efficient maikets, woulu piouuce theii wonueiful stabilizing
woik. The macioeconomy was moueleu as a woilu of iationality anu supieme
unueistanuing that unfoitunately was iegulaily hit by outsiue uistuibances.
It is no exaggeiation to state that the financial anu economic upheavals following
the ciash in the 0S subpiime maiket have unueimineu this iuyllic view of
stability cieateu in a woilu of fully iational anu fully infoimeu agents. These
upheavals have also stiengtheneu the view of those who have aigueu that
macioeconomics must take into account uepaituies fiom iationality, in
paiticulai uepaituies fiom the assumption of iational expectations.
Theie is a iisk, of couise, in tiying to mouel uepaituies fiom iationality anu
iational expectations. The pioponents of the paiauigm of the fully infoimeu
iational agent have tolu us that theie aie millions of uiffeient ways one can
uepait fiom iationality. Theie is thus no hope to come to any meaningful
conclusion once we wanuei into the woilu of iiiationality. This aigument has
been veiy poweiful. It has been useu to uiscieuit any attempt to uepait fiom the
iational anu fully infoimeu agent paiauigm. As a iesult, many acauemic
ieseaicheis have been uiscouiageu fiom uepaiting fiom the mainstieam
macioeconomic theoiy.
4
The pioblem with the objection that eveiything becomes possible when we
move into the teiiitoiy of iiiationality is that it is baseu on the view that theie is
only one possible foimulation of what a iational agent is. This is the foimulation
now founu in mainstieam macioeconomic mouels. It is my contention that one
can uepait fiom that paiticulai foimulation of iationality without having to
wanuei in the uaik woilu of iiiationality.
Ny intention is to show that once we accept the notion that inuiviuuals have
cognitive limitations, anu thus aie not capable of unueistanuing the full
complexity of the woilu (as is ioutinely assumeu in the mainstieam
macioeconomic mouels), it is possible to uevelop mouels baseu on a uiffeient
notion of iationality. I also intenu to show that his leaus to a iichei
macioeconomic uynamics that comes closei to the obseiveu uynamics of output
anu inflation than the one piouuceu by the mainstieam macioeconomic mouels.
I will stait by piesenting the stanuaiu macioeconomic mouel, i.e. the New
Keynesian mouel, whose most successful embouiment is the Bynamic Stochastic
ueneial Equilibiium (BSuE) Nouel (Chaptei 1). This will be followeu by a ciitical
analysis of this mouel (Chaptei 2). Baving cleaieu the path, I will then piesent
the main alteinative mouel, the behavioial macioeconomic mouel, in the
subsequent chapteis (chapteis S anu 4). This will then leau to an analysis of
monetaiy policies in such a behavioial mouel (chapteis S anu 6). The next two
chapteis will uiscuss the extensions to the basic mouel. 0ne extension is to
intiouuce asset maikets in the mouel (chaptei 7); anothei extension
incoipoiates a iichei menu of foiecasting iules than the ones useu in the basic
mouel (chaptei 8). Finally in chaptei 9, I uiscuss some empiiical issues ielating
to the question of how well the theoietical pieuictions of the behavioial mouel
peifoim when confionteu with the uata.
Cleaily this is not a uefinitive book. As the ieauei will finu out, in much of the
mateiial that will be piesenteu, theie aie loose enus anu uniesolveu issues. Ny
intention is to exploie new ways of thinking about the macioeconomy; ways of
thinking that uepait fiom mainstieam thinking which in my opinion has tuineu
out to be unhelpful in unueistanuing why output anu inflation fluctuate as they
uo in the ieal woilu.
S
I uevelopeu many of the iueas in this book thiough uebate with colleagues
uuiing seminais anu at othei occasions. Without implicating them I woulu like to
thank Yunus Aksoy, Tony Atkinson, William Bianch, Cail Chiaiella, Bomenico
uelli uatti, Stephan Fahi, Baniel uios, Richaiu Baiiison, Timo Benckel, Cais
Bommes, Romain Boussa, ueihaiu Illing, Noiuecai Kuiz, Pablo Roviia
Kaltwassei, Chiistian Keuschnigg, Alan Kiiman, uiovanni Lombaiuo, Lais
Ljungqvist, Patiick Ninfoiu, }ohn Nuellbauei, Ilbas Pelin, Biuce Pieston, Fiank
Smets, Robeit Solow, Leopolu von Thauuen, Baviu vines, Nike Wickens, anu
Tony Yates.

6












CHAPTER1:THENEWKEYNESIANMACROECONOMICMODEL

7
1.Introduction
In this chaptei the stanuaiu macioeconomic mouel as it has evolveu in the last
few uecaues is piesenteu. This mouel has ieceiveu uiffeient names. It is
sometimes calleu the NewKeynesian macioeconomic mouel (in contiast with
the New Classical macioeconomic mouel). It is also often calleu Bynamic
Stochastic ueneial Equilibiium mouel (BSuEmouel). The main featuies of this
mouel aie the following
Fiist it has a miciofounuation, i.e. consumeis aie assumeu to maximize theii
utilities anu piouuceis theii piofits in a uynamic (multipeiiou context). This
implies that macioeconomic equations shoulu be ueiiveu fiom this optimizing
behavioi of consumeis anu piouuceis.
Seconu, consumeis anu piouuceis aie assumeu to have Rational Expectations
(RE), i.e. they make foiecasts using all available infoimation, incluuing the
infoimation embeuueu in the mouel. The assumption of RE also implies that
agents know the tiue statistical uistiibution of all shocks hitting the economy.
They then use this infoimation in theii optimization pioceuuie. Since consumeis
anu piouuceis all use the same infoimation, we can just take one iepiesentative
consumei anu piouucei to mouel the whole economy. Theie is no heteiogeneity
in the behavioi of consumeis anu piouuceis.
Thiiu, anu this is the New Keynesian featuie, it is assumeu that piices uo not
aujust instantaneously. Although fiims continuously optimize theie aie
institutional constiaints on the speeu with which they can aujust piices to theii
optimal level. This featuie contiasts with the New Classical mouel (sometimes
also labeleu Real Business Cycle mouel) that assumes peifect piice flexibility.
Although we will use the New Keynesian mouel as oui benchmaik mouel we will
sometimes contiast the iesults of this mouel with those obtaineu in the New
Classical mouel.
This chaptei uoes not go in all the uetails of the New Keynesian mouel. Foi that
theie aie excellent textbooks (e.g. uali(2uu8), Wooufoiu(2uuS) anu
Walsh(2uu8)). The puipose of the piesent chaptei is to set the stage foi a
compaiison of the behavioial mouel that will be uevelopeu in subsequent
8
chapteis with the stanuaiu New Keynesian mouel. We will also subject the New
Keynesian mouel (BSuEmouel) to a methouological ciiticism in the next
chaptei.
2.TheNewKeynesianmacroeconomicmodel
We will use the simplest possible iepiesentation of the mouel heie.
The aggiegate uemanu equation is ueiiveu fiom utility maximization of a
iepiesentative consumei. Bow this is uone is shown in uali(2uu8), Chaptei 2
1
.
Beie we iepiesent the iesult:
(1.1)
wheie y
t
is the output gap in peiiou t, r
t
is the nominal inteiest iate, t
t
is the iate
of inflation, anu c
t
is a white noise uistuibance teim. E
t
iepiesents the
expectations (foiecasts) maue in peiiou t by the iepiesentative consumei. These
expectations aie assumeu to be foimeu using all available infoimation (iational
expectations). Note that is the ieal inteiest iate anu a
2
<0.
The aggiegate uemanu equation has a veiy simple inteipietation. 0tility
maximizing agents will want to spenu moie on goous anu seivices touay when
they expect futuie income (output gap) to inciease anu to spenu less when the
ieal inteiest iate incieases.
The aggiegate supply equation is ueiiveu fiom piofit maximization of inuiviuual
piouuceis (see uali(2uu8), chaptei S). In auuition, it is assumeu that piouuceis
cannot aujust theii piices instantaneously. Insteau, foi institutional ieasons, they
have to wait to aujust theii piices. The most populai specification of this piice
aujustment mechanism is the Calvo piicing mechanism (Calvo(198S); foi a
ciiticism see NcCallum(2uuS)). This assumes that in peiiou t, a fiaction u of
piices iemains unchangeu. 0nuei those conuitions the aggiegate supply
equation (which is often iefeiieu to as the New Keynesian Philips cuive) can be
ueiiveu as :

(1.2)

1
Other sources are Woodford(2002), or Minford and Ou(2009).
y
t
= E
t
y
t +1
+ a
2
(r
t
E
t
t
t +1
) + c
t
(r
t
E
t
t
t +1
)
t
t
= |E
t
t
t +1
+ ky
t
+ q
t
9
wheie the paiametei k is a complex expiession of the unueilying paiameteis of
the optimizing mouel (see uali(2uu8)); k is a function of the fiaction u which can
be inteipieteu as an inuex of piice iigiuity. When u = u (i.e. theie is no piice
iigiuity) k = anu when u = 1 (i.e. theie is complete piice iigiuity) k = u. The
foimei case coiiesponus to a veitical aggiegate supply cuive (the classical case)
while the lattei case coiiesponus to a hoiizontal aggiegate supply cuive (the
Keynesian case).
The pievious two equations ueteimine the two enuogenous vaiiables, inflation
anu output gap, given the nominal inteiest iate. The mouel has to be closeu by
specifying the way the nominal inteiest iate is ueteimineu. The most populai
way to uo this has been to invokeu the Tayloi iule (see Tayloi(199S)). This iule
uesciibes the behavioi of the cential bank. It is usually wiitten as follows:

(1.S)

wheie is the inflation taiget. Thus the cential bank is assumeu to iaise the
inteiest when the obseiveu inflation iate incieases ielative to the announceu
inflation taiget. The intensity with which it uoes this is measuieu by the
coefficient c
1
. Similaily when the output gap incieases the cential bank is
assumeu to iaise the inteiest iate. The intensity with which it uoes this is
measuieu by c
2
. The lattei paiametei then also tells us something about the
ambitions the cential bank has to stabilize output. A cential bank that uoes not
caie about output stabilization sets c
2
=u. We say that this cential bank applies
stiict inflation taigeting. Finally note that, as is commonly uone, the cential bank
is assumeu to smooth the inteiest iate. This smoothing behavioi is iepiesenteu
by the laggeu inteiest iate in equation (1.S).
The paiametei c
1
is impoitant. It has been shown (see Wooufoiu(2uuS), chaptei
4, oi uali(2uu8)) that it must exceeu 1 foi the mouel to be stable. This is also
sometimes calleu the Tayloi piinciple.
Iueally, the Tayloi iule shoulu be foimulateu using a foiwaiulooking inflation
vaiiable, i.e. cential banks set the inteiest iate on the basis of theii forecasts
t t t t t
u r c y c c r + + + =
1 3 2
*
1
) ( t t
*
t
1u
about the iate of inflation. This is not uone heie in oiuei to maintain simplicity in
the mouel (again see Wooufoiu(2uuS), p. 2S7)
2
.
We have auueu eiioi teims in each of the thiee equations. These eiioi teims
uesciibe the natuie of the uiffeient shocks that can hit the economy. Theie aie
uemanu shocks ,c
t
, supply shocks , q
t
, anu inteiest iate shocks, u
t
. We will
geneially assume that these shocks aie noimally uistiibuteu with mean zeio anu
a constant stanuaiu ueviation. Agents with iational expectations aie assumeu to
know the uistiibution of these shocks. It will tuin out that this quite a ciucial
assumption.
The mouel consisting of equations (1.1) to (1.S) can be wiitten in matiix notation
as follows:



(1.4)

(1.S)

This mouel can be solveu unuei iational expectations. Theie aie seveial ways
one can uo this (see Ninfoiu anu Peel(198S), Walsh(2uuS)). Beie we will use
numeiical methous to solve the system mainly because the behavioial mouel
pioposeu in futuie chapteis is highly nonlineai (in contiast with the piesent
mouel which is lineai) necessitating the use of numeiical solution techniques.
We use the BinueiPesaian(1996) pioceuuie. The Natlabcoue is pioviueu in
appenuix. The numeiical values of the paiameteis aie also piesenteu in
appenuix. They aie baseu on values commonly useu in these mouels (see
uali(2uu8), p. S2).
We use the mouel to analyze two questions that will also ietuin latei when we
uevelop the behavioial mouel. The fiist question ielates to the effectiveness of
monetaiy policy in influencing output anu inflation, anu the conuitions unuei

2
As is shown in Woodford(2003) forward looking Taylor rules may not lead to a determinate solution
even if the Taylor principle is satisfied.
1 b
2
0
0 1 a
2
c
1
c
2
1





(

(
(
(
t
t
y
t
r
t





(

(
(
(
=
b
1
0 0
a
2
a
1
0
0 0 0





(

(
(
(
E
t
t
t +1
E
t
y
t +1
E
t
r
t +1





(

(
(
(
+
q
t
c
t
u
t





(

(
(
(
O Z
t
= u E
t
Z
t +1
+v
t

Z
t
= O
1
u E
t
Z
t +1
+v
t
| |
11
which it achieves this effectiveness. This question will also leau us to an analysis
of optimal monetaiy policy. The seconu question has to uo with the capacity of
this mouel to geneiate business cycle movements.

3.Whatmonetarypolicycando.
Bow effective is monetaiy policy in influencing output anu inflation. This is the
question we analyze in this section. We uo this by computing the impulse
iesponses to an inteiest iate shock. We assume this shock to be an unanticipateu
inciease in the inteiest iate, i.e. an inciease in the stochastic shock u
t
in equation
(1.S) by 1 peicentage point (1uu basis points). This shock occuis in peiiou 1.
The impulse iesponse function then tiaces how output anu inflation aie affecteu
ovei time
S
. We apply the same shock foi uiffeient values of the paiametei k in
the New Keynesian Philips cuive which, as was mentioneu eailiei, measuies the
uegiee of piice flexibility.
Fiom Figuie 1.1 we uiaw the following conclusion. Fiist, when piice iigiuity is
high (low flexibility), an unanticipateu inciease in the inteiest iate has a
ielatively stiong effect on the output gap. The effect on inflation is then ielatively
small. Thus with piice iigiuity, monetaiy policy can have a stiong ieal effect
(i.e. an effect on output. Seconu, the effect of monetaiy policy on the output gap
is tempoiaiy. Aftei some time the output gap ietuins to its equilibiium value.
Thiiu, when flexibility incieases, the impact of a change in the inteiest iate on
output ueclines, while the impact on the iate of inflation incieases. In the limit
when flexibility is peifect (k= ) changes in the inteiest iate have no impact on
the output gap anymoie. It is saiu that monetaiy policy is neutial: it uoes not
affect ieal vaiiables; it only affects the iate of inflation.
The pievious iesults leau to the conclusion that the existence of piice iigiuities
cieates a potential foi the cential bank to influence output. This is the iationale

S
These impulse iesponse functions uesciibe the path of one of the enuogenous vaiiables (output
gap, inflation) following the occuiience of the shock. In oiuei to uo so we simulate two seiies of
these enuogenous vaiiables. 0ne is the seiies without the shock (the benchmaik seiies); the
othei is the seiies with the shock. We then subtiact the fiist fiom the seconu one. This yielus a
new seiies, the impulse iesponse, that shows how the enuogenous vaiiable that embouies the
shock evolves ielative to the benchmaik.

12
pioviueu by New Keynesian macioeconomic mouel foi output stabilization. Such
iationale uoes not exist in the New Classical mouel that assumes peifect piice
flexibility.

Figure1.1:Impulseresponsesofoutputandinflationtointerestrate
increase
Low flexibility: k = u.uS

Neuium flexibility: k = u.S

Bigh flexibility: k = S

1S
The fact that the cential bank can affect output in the piesence of piice iigiuities
uoes not necessaiily mean that it shoulu uo so. In oiuei to analyze the
uesiiability of such stabilization one has to peifoim a welfaie analysis of
stabilization policies. The way we will uo this heie is to ueiive the tiaueoff
between inflation anu output vaiiability faceu by the cential bank.

4.Whatmonetarypolicyshoulddo:tradeoffbetweenoutputandinflation
variability.

The tiaueoffs aie constiucteu as follows. Figuie 1.2 shows how output vaiiability
(panel a) anu inflation vaiiability (panel b) change as the output coefficient (c
2
)
in the Tayloi iule incieases fiom u to 1. Each line iepiesents the outcome foi
uiffeient values of the inflation coefficient (c
1
) in the Tayloi iule.
Panel a showing the evolution of output vaiiability exhibits the expecteu iesult:
as the output coefficient incieases (i.e. the cential bank incieases its attempt at
stabilizing output) output vaiiability tenus to ueciease. This uecline in output
vaiiability, howevei, comes at a piice. This is shown in panel b. The uecline in
output vaiiability iesulting fiom moie active stabilization comes at the cost of
moie inflation vaiiability. Note also that when the inflation coefficient (c
1
)
incieases the vaiiability of output incieases. This is seen fiom the fact that in
panel a the lines shift up when c
1
incieases. Thus moie attention by the cential
bank foi inflation contiol incieases output vaiiability. In panel b the opposite
happens: when c
1
incieases the vaiiability of inflation ueclines.
The combination of panels a anu b into one allows us to ueiive the tiaueoff. This
is shown in panel c of Figuie 1.2, which has the vaiiability of inflation on the
veitical axis anu the vaiiability of output on the hoiizontal axis. We now obtain
uownwaiu sloping lines (tiaueoffs). These iepiesent the piice the cential bank
pays in teims of inflation vaiiability when it attempts to ieuuce output volatility.
Put uiffeiently, when the cential bank succeeus in ieuucing output vaiiability it
uoes this at the cost of highei inflation vaiiability. We obtain a uiffeient tiaueoff
foi eveiy value of the inflation paiametei c
1
, anu we obseive that when c
1

incieases the tiaueoff exhibits a uownwaiu movement. Thus, stiictei inflation
taigeting tenus to impiove the tiaueoff. Theie is a limit though. Foi values of c
1

14
aiounu 2 the uownwaiu shifts tenu to stop. We achieve an efficient fiontiei, i.e.
the lowest possible combinations of inflation anu output volatility that can be
achieveu by the cential bank. Theie is a choice to be maue. This choice will then
uepenu on the piefeiences of the cential bank, which hopefully iepiesent the
piefeiences of society.

Figure1.2:Tradeoffsbetweeninflationandoutputvariability

panel a panel b

panel c


This analysis of the optimal amount of stabilization in the New Keynesian mouel
is elegant anu impoitant. Its powei, of couise, uepenus on the existence of piice
iigiuities. In the absence of such iigiuities, the tiaueoff between inflation anu
output volatility uisappeais. In the limit of complete piice flexibility (k = ) the
lines in panel a become hoiizontal anu coinciue foi all values of c
1
, i.e. when the
cential bank incieases its output stabilization attempts this has no effect on the
volatility of output; in panel b these lines aie also hoiizontal but shift uown when
c
1
incieases, i.e. the cential bank can ieuuce inflation volatility by tightei
1S
inflation taigeting. All this then iesults in a veitical tiaueoff in panel c, i.e. the
cential bank can only affect inflation volatility, not output volatility.

5.ThebusinesscycletheoryoftheNewKeynesianmodel
Capitalism is chaiacteiizeu by booms anu busts; peiious of stiong giowth in
output followeu by peiious of ueclines in economic giowth. Eveiy macio
economic theoiy shoulu make an attempt at explaining these enuemic business
cycle movements. Bow uoes the New Keynesian mouel explain booms anu busts
in economic activity.
In oiuei to answei this question it is useful to piesent some stylizeu facts about
the cyclical movements of output. In Figuie 1.S we show the movements of the
output gap in the 0S since 196u. We obseive stiong cyclical movements. These
cyclical movements imply that theie is stiong autocoiielation in the output gap
numbeis, i.e. the output gap in peiiou t is stiongly coiielateu with the output gap
in peiiou t1. The intuition is that if theie aie cyclical movements we will obseive
clusteiing of goou anu bau times. A positive (negative) output gap is likely to be
followeu by a positive (negative) output gap in the next peiiou. This is what we
finu foi the 0S output gap ovei the peiiou 196u2uu9: the autocoiielation
coefficient is u.94. Similai autocoiielation coefficients aie founu in othei
countiies.
A seconu stylizeu fact founu about the movements in the output gap is that these
aie not noimally uistiibuteu. We show the eviuence foi the 0S in Figuie 1.4. We
finu, fiist, that theie is excess kuitosis (kuitosis= S.62), which means that theie
is too much concentiation of obseivations aiounu the mean. Seconu, we finu that
theie aie fat tails, i.e. theie aie moie laige movements in the output gap than is
compatible with the noimal uistiibution. This also means that if we weie basing
oui foiecasts on the noimal uistiibution we woulu unueiestimate the piobability
that in any one peiiou a laige inciease oi ueciease in the output gap can occui.
Finally, the }aiqueBeia test leaus to a foimal iejection of noimality of the
movements in the 0S output gap seiies.

16
Figure1.3

Souice: 0S Bepaitment of Commeice anu Congiessional Buuget 0ffice
Figure1.4:frequencydistributionofUSOutputgap(19602009)

Souice: 0S Bepaitment of Commeice anu Congiessional Buuget 0ffice
kuitosis: S.61; }aiqueBeia: 7.17 with pvalue=u.u27

Against this empiiical backgiounu we analyze the movements of the output gap
as pieuicteu by the New Keynesian mouel. We fiist show simulations of the
output gap unuei piice iigiuity, assuming white noise shocks, in figuie 1.S. It is
-0,1
-0,08
-0,06
-0,04
-0,02
0
0,02
0,04
0,06
0,08
1
9
6
0
Q
1
1
9
6
2
Q
3
1
9
6
5
Q
1
1
9
6
7
Q
3
1
9
7
0
Q
1
1
9
7
2
Q
3
1
9
7
5
Q
1
1
9
7
7
Q
3
1
9
8
0
Q
1
1
9
8
2
Q
3
1
9
8
5
Q
1
1
9
8
7
Q
3
1
9
9
0
Q
1
1
9
9
2
Q
3
1
9
9
5
Q
1
1
9
9
7
Q
3
2
0
0
0
Q
1
2
0
0
2
Q
3
2
0
0
5
Q
1
2
0
0
7
Q
3
Output Gap US 1960-2009
17
immeuiately cleai that the New Keynesian mouel fails to mimic the typical
business cycle movements in the output gap iuentifieu eailiei. These movements
in Figuie 1.S aie essentially white noise. The autocoiielation coefficient
between subsequent output gaps is only u.u6 suggesting that theie is no
coiielation between subsequent output gaps, anu thus veiy little cyclical
movement.
The lowei panel of figuie 1.S shows the fiequency uistiibution of the simulateu
output gaps. We obseive that these output gaps aie noimally uistiibuteu (The
}aiqueBeia test is unable to ieject noimality). This contiasts veiy much with the
nonnoimality obseiveu in the ieal uata (Figuie 1.4).
Thus the simple New Keynesian mouel fails to captuie the typical featuies of ieal
life business cycle movements, i.e. the coiielation between subsequent
obseivations of the output gap (autocoiielation) anu the occuiience of laige
booms anu busts (fat tails). In this sense one can say that the New Keynesian
mouel piesenteu in the pievious sections uoes not have an inteiesting theoiy of
the business cycle. In fact it has no theoiy of the business cycle.
In oiuei to piouuce a mouel that comes closei in mimicking ieallife business
cycle movements New Keynesians have aujusteu the basic mouel in two ways.
The fiist one consisteu in auuing lags in the uemanu anu supply equations so as
to piouuce moie ineitia anu to bettei mimic the autocoiielation in the uata. The
seconu one consisteu in auuing moie stiuctuie in the eiioi teims in the uiffeient
equations of the mouel. We now uiscuss these two attempts.


18
Figure1.5:SimulatedoutputgapinNewKeynesianmodel

kuitosis: S.u; }aiqueBeia: u.u1 with pvalue=u.S

6.Theneedforinertia
Theie aie two featuies of the New Keynesian mouel uiscusseu in the pievious
sections that aie unsatisfactoiy anu that coulu explain the lack of pieuictive
powei of the mouel. The fiist one is that it assumes that consumeis aujust theii
optimal plans instantaneously. This is uniealistic. Theie is, foi example, habit
foimation that has the effect of slowing uown the aujustment of consumption to
its optimal level aftei some shock. In oiuei to ueal with this, macioeconomists
19
have intiouuceu habit foimation explicitly in consumeis optimization pioblem
(see Smets anu Wouteis(2uu7)). This has the effect of intiouucing a lag in the
aggiegate uemanu equation. The aggiegate uemanu equation is theiefoie
iewiitten as:
(1.6)
wheie u < a
1
<1

We have auueu a laggeu output gap. As a iesult, theie is now a foiwaiulooking
component in the aggiegate uemanu equation (the fiist teim on the iight hanu
siue) anu a backwaiu looking component (the seconu teim). a
1
tenus to uecline
with the uegiee of habit foimation.
A seconu unsatisfactoiy featuie of the New Keynesian mouel of the pievious
section is that it ielies too much on the Calvo piice foimation mouel. In this
mouel fiims get a lotteiy ticket that will ueteimine whethei in peiiou t they will
be alloweu to aujust theii piice. If they uiaw the wiong numbei they have to
wait until a new peiiou when again they get a new lotteiy ticket. This is ceitainly
an unattiactive featuie, mainly because the piice aujustment piocess in the
Calvo piicing mouel is state inuepenuent (NcCallum(2uuS)). In piactice the
uesiie to aujust piices will veiy much uepenu on the state of the economy. 0ne
way out of this pioblem is to assume that fiims that have uiawn the wiong
lotteiy numbei will aujust theii piices using an inuexing pioceuuie (i.e. inuex to
pievious piices). This extension of the Calvo piicing mouel is now the stanuaiu
pioceuuie in New Keynesian mouels (BSuEmouels). We follow this pioceuuie
heie. The new aggiegate supply equation (New Keynesian Philips cuive)
becomes:

(1.7)

As in the uemanu equation we obtain a foiwaiu looking (fiist teim RBS) anu a
backwaiu looking (seconu teim RBS) inflation vaiiable. The ielative impoitance
of the foiwaiu anu backwaiu looking teims is measuieu by b
1
(u < b
1
< 1).
Equations (1.6) anu (1.7) aie now the stanuaiu aggiegate uemanu anu supply
equations implicit in the BSuEmouels. We will theiefoie use them heie. We ask
y
t
= a
1
E
t
y
t +1
+ (1 a
1
) y
t 1
+ a
2
(r
t
E
t
t
t +1
) + c
t
t
t
= b
1
E
t
t
t +1
+ (1 b
1
)t
t 1
+ b
2
y
t
+ q
t
2u
the question how this extension of the basic New Keynesian mouel impioves its
empiiical peifoimance.
We show the movements of the simulateu output gap (assuming a
1
= u.S anu b
1
=
u.S) in Figuie 1.6. The uppei panel shows the output gap in the time uomain anu
the lowei panel in the fiequency uomain. We now obtain movements that come
closei to cyclical movements: the autocoiielation in the output gap is u.77. This
is still significantly lowei than in the obseiveu uata (foi the 0S we founu u.94).
In auuition, these output gap movements aie still noimally uistiibuteu (see
lowei panel). We coulu not ieject that the uistiibution is noimal. Thus, although
the extenueu New Keynesian mouel comes closei to explaining typically
obseiveu business cycle movements, it is still fai iemoveu fiom a satisfactoiy
explanation.
The next step in making this mouel moie empiiically ielevant has consisteu in
auuing autocoiielation in the eiioi teims. This is now the stanuaiu pioceuuie in
BSuEmouels (see Smets anu Wouteis(2uuS)). We uo the same with oui veision
of the New Keynesian mouel anu assume that the autocoiielation of the eiioi
teims in the thiee equations (1.6, 1.7 anu 1.S) is equal to u.9. The iesult of this
assumption is shown in the simulations of the output gap in Figuie 1.7. We now
obtain movements of the output gap that iesemble ieallife movements. The
autocoiielation of the output gap is now u.98, which is veiy close to the obseiveu
numbei of u.94 in the postwai 0S output gap. We still cannot ieject noimality
though (see the }aiqueBeia test). This is a pioblem that, as we will see latei,
BSuEmouels have not been able to solve.



21
Figure1.6:SimulatedoutputgapinextendedNewKeynesianmodel



kuitosis: 2.9; }aiqueBeia: 1.uS with pvalue=u.S



22
Figure1.7:SimulatedoutputgapinextendedNewKeynesianmodeland
autocorrelatederrors



kuitosis: S.16; }aiqueBeia: S.2 with pvalue=u.17


Let us sum up what we have founu about the capacity of the New Keynesian
mouel (BSuEmouels) to explain cyclical movements in output. Fiist, the simple
veision of the mouel (without lags in the tiansmission piocess anu with white
noise eiioi teims) uoes not piouuce any business cycle uynamics. Seconu, in
oiuei to obtain business cycle movements (anu thus autocoiielation in output)
lags in the aggiegate uemanu anu supply equations must be intiouuceu. This is a
sensible thing to uo because even iational agents can often not aujust theii
optimal plans about consuming anu piouucing instantaneously. This extenueu
2S
mouel then piouuces autocoiielation in output but typically not sufficiently so to
come close to explaining the uynamics of the business cycle. The lattei is also
chaiacteiizeu by the existence of fat tails, i.e. the iegulai occuiience of booms
anu busts.
Thiiu, in oiuei to mimic business cycle movements, the New Keynesian (BSuE)
mouel builueis have hau iecouise to intiouucing autocoiielation in the eiioi
teims (the shocks that hit the economy). This tiick has alloweu BSuEmouels to
closely fit obseiveu uata (see Smets anu Wouteis(2uuS)). This success has been
limiteu to the fiist anu seconu moments of the movements of output, but not to
the highei moments (kuitosis, fat tails). The lattei failuie has the implication
that in oiuei to explain a laige movement in output (e.g a ueep iecession, oi a
stiong boom) BSuEmouels have to iely on laige unpieuictable shocks.
Theie aie two pioblems with this theoiy of the business cycle implicit in the
BSuEmouels.
Fiist, business cycles in BSuEmouels aie not the iesult of an enuogenous
uynamics. They occui as a iesult of exogenous shocks anu slow tiansmission of
these shocks. Put uiffeiently, the BSuEmouels pictuie a woilu populateu by
iational agents who aie fully infoimeu. In such a woilu theie woulu nevei be
business cycles. The lattei aiise because of exogenous uistuibances anu of
constiaints on agents ability to ieact instantaneously to these shocks. Thus a
given shock will piouuce iipple effects in the economy, i.e. cyclical movements.
A seconu pioblem is methouological. When the New Keynesian mouel is testeu
empiiically the ieseaichei finus that theie is a lot of the output uynamics that is
not pieuicteu by the mouel. This unexplaineu uynamics is then to be founu in the
eiioi teim. So fai so goou. The next step taken by BSuEmoueleis is to concluue
that these eiiois (typically autocoiielateu) shoulu be consiueieu to be
exogenous shocks.
The pioblem with this appioach is that it is not scientific. When the BSuE
mouelei finus a uynamics not pieuicteu by the mouel he ueciues that the New
Keynesian mouel must neveitheless be iight (because theie can be no uoubt that
inuiviuual agents aie iational) anu that thus the ueviation between the obseiveu
24
uynamics anu the one pieuicteu by the mouel must come fiom outsiue the
mouel.
Nacioeconomic theoiy must uo bettei than the cuiient stanuaiu BSuE mouel
uoes. It is the ambition of this book to suggest how this can be uone. Befoie we
uo this some auuitional methouological issues in the cuiient BSuEmouels must
be uiscusseu. This is uone in the next chaptei.




2S
















CHAPTER2:THESCIENTIFICFOUNDATIONOF

THENEWKEYNESIANMACROECONOMICMODEL

26
1. I ntroduction
In the previous chapter we analyzed the main characteristics of the New Keynesian
macroeconomic model (the DSGE-model). We concluded that this model has a
particular, problematic, view of the business cycle. In this chapter we subject this
model to a more intense methodological criticism.
One of the surprising developments in macroeconomics is the systematic
incorporation of the paradigm of the utility maximizing forward looking and fully
informed agent into macroeconomic models. This development started with the
rational expectations revolution of the 1970s, which taught us that macroeconomic
models can be accepted only if agents expectations are consistent with the underlying
model structure. The real business cycle theory (RBC) introduced the idea that
macroeconomic models should be micro-founded, i.e., should be based on dynamic
utility maximization (Kydland and Prescott(1982)). While RBC model had no place
for price rigidities and other inertia (thats why it is sometimes called the New
Classical model), the New Keynesian School systematically introduced rigidities of
different kinds into similar micro-founded models. These developments occurred in
the ivory towers of academia for several decades until in recent years these models
were implemented empirically in such a way that they have now become tools of
analysis in the boardrooms of central banks. The most successful implementation of
these developments are to be found in the Dynamic Stochastic General Equilibrium
models (DSGE-models) that are increasingly used in central banks for policy analysis
(see Smets and Wouters 2003; Christiano et al. 2007; Smets and Wouters 2007;
Adjemian et al. 2007).
These developments are surprising for several reasons. First, while macroeconomic
theory enthusiastically embraced the view that agents fully understand the structure of
the underlying models in which they operate, other sciences like psychology and
neurology increasingly uncovered the cognitive limitations of individuals (see e.g.
Damasio 2003; Kahneman 2002; Camerer et al. 2005). We learn from these sciences
that agents understand only small bits and pieces of the world in which they live, and
instead of maximizing continuously taking all available information into account,
agents use simple rules (heuristics) in guiding their behavior and their forecasts about
27
the future. This raises the question of whether the micro-founded macro-economic
theory that has become the standard is well grounded scientifically.
A second source of surprise in the development of macroeconomic modeling in
general and the DSGE-models in particular is that other branches of economics, like
game theory and experimental economics have increasingly recognized the need to
incorporate the limitations agents face in understanding the world. This has led to
models that depart from the rational expectations paradigm (see e.g. Thaler 1994).
Standard macroeconomics has been immune for these developments. True, under
the impulse of Sargent (1993) and Evans and Honkapohja (2001) there has been an
attempt to introduce the notion in macroeconomic models that agents should not be
assumed to be cleverer than econometricians and that therefore they should be
modeled as agents who learn about the underlying model as time passes. This has led
to learning in macroeconomics. The incorporation of learning in macroeconomics,
however, has up to now left few traces in standard macroeconomic models and in the
DSGE-models.

2. Plausibility and empirical validity of rational expectations.
The New Keynesian DSGE-models embody the two central tenets of modern
macroeconomics. The first one is that a macroeconomic model should be based
(micro founded) on dynamic utility maximization of a representative agent. The
second one is that expectations should be model-consistent which implies that agents
make forecasts based on the information embedded in the model. This idea in turn
implies that agents have a full understanding of the structure of the underlying model.
In this chapter we analyze the scientific validity of these underlying assumptions of
the DSGE-models. In addition we analyze in very general terms the implications of
these assumptions for macroeconomic modeling.
There can be no doubt that this approach to macroeconomics has important
advantages compared to previous macroeconomic models. The main advantage is that
it provides for a coherent and self-contained framework of analysis. This has great
intellectual appeal. There is no need to invoke ad-hoc assumptions about how agents
28
behave and how they make forecasts. Rational expectations and utility maximization
introduce discipline in modeling the behavior of agents.
The scientific validity of a model should not be based on its logical coherence or
on its intellectual appeal, however. It can be judged only on its capacity of making
empirical predictions that are not rejected by the data. If it fails to do so, coherent and
intellectually appealing models should be discarded. Before turning our attention to
the empirical validation of models based on dynamic utility maximization and rational
expectations, of which the DSGE-models are now the most prominent examples, we
analyze the plausibility of the underlying assumptions about human behavior in these
models.
There is a very large literature documenting deviations from the paradigm of the
utility maximizing agent who understands the nature of the underlying economic
model. For recent surveys, see Kahneman and Thaler (2006) and Della Vigna (2007).
This literature has followed two tracks. One was to question the idea of utility
maximization as a description of agents behavior (see Kirchgssner 2008 for an
illuminating analysis of how this idea has influenced social sciences). Many
deviations have been found. A well-known one is the framing effect. Agents are often
influenced by the way a choice is framed in making their decisions (see Tversky and
Kahneman 1981). Another well-known deviation from the standard model is the fact
that agents do not appear to attach the same utility value to gains and losses. This led
Kahneman and Tversky (1973) to formulate prospect theory as an alternative to the
standard utility maximization under uncertainty.
We will not deal with deviations from the standard utility maximization model
here, mainly because many (but not all) of these anomalies can be taken care of by
suitably specifying alternative utility functions. Instead, we will focus on the
plausibility of the rational expectations assumption and its logical implication, i.e.,
that agents understand the nature of the underlying model.
It is no exaggeration to say that there is now overwhelming evidence that
individual agents suffer from deep cognitive problems limiting their capacity to
understand and to process the complexity of the information they receive.
Many anomalies that challenge the rational expectations assumption were
discovered (see Thaler 1994 for spirited discussions of these anomalies; see also
29
Camerer and Lovallo 1999; Read and van Leeuwen 1998; Della Vigna 2007). We just
mention "anchoring" effects here, whereby agents who do not fully understand the
world in which they live are highly selective in the way they use information and
concentrate on the information they understand or the information that is fresh in their
minds. This anchoring effect explains why agents often extrapolate recent movements
in prices.
In general the cognitive problem which agents face leads them to use simple rules
("heuristics") to guide their behavior (see Gabaix, et al. 2006). They do this not
because they are irrational, but rather because the complexity of the world is
overwhelming. In a way it can be said that using heuristics is a rational response of
agents who are aware of their limited capacity to understand the world. The challenge
when we try to model heuristics will be to introduce discipline in the selection of rules
so as to avoid that everything becomes possible.
One important implication of the assumption that agents know the underlying
models structure is that all agents are the same. They all use the same information set
including the information embedded in the underlying model. As a result, DSGE-
models routinely restrict the analysis to a representative agent to fully describe how
all agents in the model process information. There is no heterogeneity in the use and
the processing of information in these models. This strips models based on rational
expectations from much of their interest in analyzing short-term and medium-term
macroeconomic problems which is about the dynamics of aggregating heterogeneous
behavior and beliefs (see Solow(2005, Colander et al. 2009)
4
. As will become
abundantly clear in this book the dynamics of interacting agents with limited
understanding but often with different strongly held beliefs is what drives the business
cycle. In standard DSGE-models this dynamics is absent creating a very shallow
theory of the business cycle. We will return to these issues in the following chapters.
It is fair to conclude that the accumulated scientific evidence casts doubts about the
plausibility of the main assumption concerning the behavior of individual agents in
DSGE-models, i.e., that they are capable of understanding the economic model in
which they operate and of processing the complex information distilled from this

4
There have been attempts to model heterogeneity of information processing in rational
expectations models. These have been developed mainly in asset market models. Typically, it
is assumed in these models that some agents are fully informed (rational) while others, the
noise traders, are not. See e.g. De Long, et al. (1990).
Su
model. Instead the scientific evidence suggests that individual agents are not capable
of doing so, and that they rely on rules that use only small parts of the available
information.
One could object here and argue that a model should not be judged by the
plausibility of its assumptions but rather by its ability to make powerful empirical
predictions. Thus, despite the apparent implausibility of its informational assumption,
the macroeconomic model based on rational expectations could still be a powerful
one if it makes the right predictions. This argument, which was often stressed by
Milton Friedman, is entirely correct. It leads to the question of the empirical validity
of the rational macromodels in general and the DSGE-models in particular.
We have discussed the failure of the DSGE-models to predict a dynamics that
comes close to the dynamics of the observed output movements, except when the step
is taken to assume that the unexplained dynamics in the error terms is in fact an
exogenous force driving an otherwise correct model. This problem of standard
DSGE-models has also been noted by Chari, et al (2008), who conclude that most of
the dynamics produced by the standard DSGE-model (e.g. Smets and Wouters(2003))
comes from the autoregressive error terms, i.e. from outside the model.
The correct conclusion from such an empirical failure should be to question the
underlying assumptions of the model. But surprisingly, this has not been done by
DSGE-modelers who have kept their faith in the existence of rational and fully
informed agents.
The issue then is how much is left over from the paradigm of the fully informed
rational agent in the existing DSGE-models? This leads to the question of whether it
is not preferable to admit that agents behavior is guided by heuristics, and to
incorporate these heuristics into the model from the start, rather than to pretend that
agents are fully rational but to rely in a nontransparent way on statistical tricks to
improve the fit of the model. That is what we plan to do in the next chapter.

3. Top-Down versus Bottom-Up models
In order to understand the nature of different macroeconomic models it is useful to
make a distinction between top-down and bottom-up systems. In its most general
definition a top-down system is one in which one or more agents fully understand the
S1
system. These agents are capable of representing the whole system in a blueprint that
they can store in their mind. Depending on their position in the system they can use
this blueprint to take over the command, or they can use it to optimize their own
private welfare. These are systems in which there is a one to one mapping of the
information embedded in the system and the information contained in the brain of one
(or more) individuals. An example of such a top-down system is a building that can
be represented by a blueprint and is fully understood by the architect.
Bottom-up systems are very different in nature. These are systems in which no
individual understands the whole picture. Each individual understands only a very
small part of the whole. These systems function as a result of the application of
simple rules by the individuals populating the system. Most living systems follow this
bottom-up logic (see the beautiful description of the growth of the embryo by
Dawkins(2009)). The market system is also a bottom-up system. The best description
made of this bottom-up system is still the one made by Hayek(1945). Hayek argued
that no individual exists who is capable of understanding the full complexity of a
market system. Instead individuals only understand small bits of the total information.
The main function of markets consists in aggregating this diverse information. If there
were individuals capable of understanding the whole picture, we would not need
markets. This was in fact Hayeks criticism of the socialist economists who took the
view that the central planner understood the whole picture, and would therefore be
able to compute the whole set of optimal prices, making the market system
superfluous. (For further insightful analysis see Leijonhufvud(1993)).
The previous discussion leads to the following interesting and surprising insight.
Macroeconomic models that use the rational expectations assumption are the
intellectual heirs of these central-planning models. Not in the sense that individuals in
these rational expectations models aim at planning the whole, but in the sense that, as
the central planner, they understand the whole picture. Individuals in these rational
expectations models are assumed to know and understand the complex structure of
the economy and the statistical distribution of all the shocks that will hit the economy.
These individuals then use this superior information to obtain the optimum
optimorum for their own private welfare. In this sense they are top-down models.
In the next chapters the rational expectations top-down model will be contrasted with
a bottom-up macroeconomic model. This will be a model in which agents have
S2
cognitive limitations and do not understand the whole picture (the underlying model).
Instead they only understand small bits and pieces of the whole model and use simple
rules to guide their behavior. Rationality will be introduced in the model through a
selection mechanism in which agents evaluate the performance of the rule they are
following and decide to switch or to stick to the rule depending on how well the rule
performs relative to other rules. As will be seen, this leads to a surprisingly rich
dynamics that comes much closer in understanding the dynamics producing short-
term macroeconomic fluctuations that the standard DSGE-models.

SS









CHAPTER3:ABEHAVIORALMACROECONOMICMODEL

S4
3.1Introduction

Theie is a neeu to uevelop macioeconomic mouels that uo not impose

implausible cognitive abilities on inuiviuual agents. In this chaptei an attempt is
maue at ueveloping such a mouel. In auuition, this chaptei aims at highlighting
the implications this mouel has foi oui unueistanuing of the woikings of the
macioeconomy anu the business cycle.
The builuing blocks of the mouel consist of the same equations as those useu in
the stanuaiu macioeconomic mouel that was uiscusseu in chaptei 1. It consists
of an aggiegate uemanu equation, an aggiegate supply equation anu a Tayloi
iule equation. The uiffeience with the stanuaiu mouel will be in the way agents
use infoimation to make foiecasts. That is, it will be assumeu that agents use
simple iules, heuiistics, to foiecast the futuie. In this chaptei, the simplest
possible heuiistic will be assumeu. In a latei chaptei (chaptei 7) othei iules aie
intiouuceu. This will be uone to stuuy how moie complexity in the heuiistics
affects the iesults.
Agents who use simple iules of behavioi aie no fools. They use simple iules only
because the ieal woilu is too complex to unueistanu, but they aie willing to leain
fiom theii mistakes, i.e. they iegulaily subject the iules they use to some
ciiteiion of success. Theie aie essentially two ways this can be uone. The fiist
one is calleu statistical leaining. It has been pioneeieu by Saigent(199S) anu
Evans anu Bonkapohja(2uu1). It consists in assuming that agents leain like
econometiicians uo. They estimate a iegiession equation explaining the vaiiable
to be foiecasteu by a numbei of exogenous vaiiables. This equation is then useu
to make foiecasts. When new uata become available the equation is ie
estimateu. Thus each time new infoimation becomes available the foiecasting
iule is upuateu. The statistical leaining liteiatuie leaus to impoitant new insights
(see e.g. Bullaiu anu Nitia(2uu2), uaspai anu Smets(2uu6), 0iphaniues anu
Williams(2uu4), Nilani(2uu7a), Bianch anu Evans(2uu9)). Bowevei, this
appioach loaus inuiviuual agents with a lot of cognitive skills that they may oi
SS
may not have
S
. I will insteau use anothei leaining stiategy that can be calleu
tiial anu eiioi leaining. It is also often labeleu auaptive leaining. I will use
both labels as synonyms.
Auaptive leaining is a pioceuuie wheieby agents use simple foiecasting iules
anu then subject these iules to a fitness test, i.e., agents enuogenously select
the foiecasting iules that have ueliveieu the highest peifoimance (fitness) in
the past. Thus, an agent will stait using one paiticulai iule. She will iegulaily
evaluate this iule against the alteinative iules. If the foimei iule peifoims well,
she keeps it. If not, she switches to anothei iule. In this sense the iule can be
calleu a tiial anu eiioi iule.
This tiial anu eiioi selection mechanism acts as a uisciplining uevice on the
kinu of iules that aie acceptable. Not eveiy iule is acceptable. It has to peifoim
well. What that means will be maue cleai latei. It is impoitant to have such a
uisciplining uevice, otheiwise eveiything becomes possible. The neeu to
uiscipline the foiecasting iule was also one of the basic justifications unueilying
iational expectations. By imposing the conuition that foiecasts must be
consistent with the unueilying mouel, the mouel builuei seveiely limits the iule
that agents can use to make foiecasts. The auaptive selections mechanism useu
heie plays a similai uisciplining iole.
Theie is anothei impoitant implication of using tiial anu eiioi iules that
contiasts a gieat ueal with the iational expectations foiecasting iule. As will be
iemembeieu, using iational expectations implies that agents unueistanu the
complex stiuctuie of the unueilying mouel. Since theie is only one unueilying
mouel (theie is only one Tiuth), agents unueistanu the same Tiuth. They all
make exactly the same foiecast. This allows builueis of iational expectations
mouels to focus on just one iepiesentative agent. In the auaptive leaining
mechanism that will be useu heie, this will not be possible because agents can
use uiffeient foiecasting iules. Thus theie will be heteiogeneity among agents.
This is an impoitant featuie of the mouel because, as will be seen, this
heteiogeneity cieates inteiactions between agents. These inteiactions ensuie

5
See the fascinating book of Gigerenzer and Todd(1999) which argues that individual agents
experience great difficulties in using statistical learning techniques. It has a fascinating analysis on the
use of simple heuristics as compared to statistical (regression) learning.
S6
that agents influence each othei, leauing to a uynamics that is completely absent
fiom iational expectations mouels.

3.2Themodel

The mouel consists of an aggiegate uemanu equation, an aggiegate supply
equation anu a Tayloi iule.
As in chaptei 1, the aggiegate uemanu equation is specifieu in the stanuaiu way.
Foi the sake of convenience the equation is iepeateu heie, i.e.

(S.1)

wheie y
t
is the output gap in peiiou t, r
t
is the nominal inteiest iate, t
t
is the iate
of inflation, anu c
t
is a white noise uistuibance teim. The uiffeience with the
uemanu equation of chaptei 1 is that iational expectations aie not assumeu. That
is why I place a tilue above E. Thus is the expectations opeiatoi wheie the
tilue iefeis to expectations that aie not foimeu iationally. Bow exactly these
expectations aie foimeu will be specifieu subsequently.
I follow the pioceuuie intiouuceu in New Keynesian BSuEmouels of auuing a
laggeu output in the uemanu equation. This can be justifieu by invoking ineitia in
uecision making (see chaptei 1). It takes time foi agents to aujust to new signals
because theie is habit foimation oi because of institutional constiaints. Foi
example, contiacts cannot be ienegotiateu instantaneously. I keep this
assumption of ineitia heie. Bowevei, I will analyze latei how much the iesults
uepenu on this ineitia.
The aggiegate supply equation is ueiiveu fiom piofit maximization of inuiviuual
piouuceis (see chaptei 1). As in BSuEmouels, a Calvo piicing iule anu some
inuexation iule useu in aujusting piices is assumeu. This leaus to a laggeu
inflation vaiiable in the equation
6
. The supply cuive can also be inteipieteu as a
New Keynesian Philips cuive:

6
It is now standard in DSGE-models to use a pricing equation in which marginal costs enter on the
right hand side. Such an equation is derived from profit maximisation in a world of imperfect
t t t t t t t t
E r a y a y E a y c t + + + =
+ +
)
~
( ) 1 (
~
1 2 1 1 1 1
t
E
~
S7
(S.2)

Finally the Tayloi iule uesciibes the behavioi of the cential bank

(S.S)

wheie is the inflation taiget which foi the sake of convenience will be set
equal to u. The cential bank is assumeu to smooth the inteiest iate. This
smoothing behavioi is iepiesenteu by the laggeu inteiest iate in equation (S.S).

Introducingheuristicsinforecastingoutput
Agents aie assumeu to use simple iules (heuiistics) to foiecast the futuie output
anu inflation. The way I pioceeu is as follows. I assume two types of foiecasting
iules. A fiist iule can be calleu a funuamentalist one. Agents estimate the
steauy state value of the output gap (which is noimalizeu at u) anu use this to
foiecast the futuie output gap. (In a latei extension in chaptei 7, it will be
assumeu that agents uo not know the steauy state output gap with ceitainty anu
only have biaseu estimates of it). A seconu foiecasting iule is an extiapolative
one. This is a iule that uoes not piesuppose that agents know the steauy state
output gap. They aie agnostic about it. Insteau, they extiapolate the pievious
obseiveu output gap into the futuie.
The two iules aie specifieu as follows
The funuamentalist iule is uefineu by (S.4)

The extiapolative iule is uefineu by (S.S)
This kinu of simple heuiistic has often been useu in the behavioial finance
liteiatuie wheie agents aie assumeu to use funuamentalist anu chaitist iules
(see Biock anu Bommes(1997), Bianch anu Evans(2uu6), Be uiauwe anu
uiimalui(2uu6)). It is piobably the simplest possible assumption one can make
about how agents who expeiience cognitive limitations, use iules that embouy
limiteu knowleuge to guiue theii behavioi. They only iequiie agents to use

competition. It can be shown that under certain conditions the aggregate supply equation (3.2) is
equivalent to such a pricing equation (see Gali(2008), Smets and Wouters(2003)).
t t t t t t
y b b E b q t t t + + + =
+ 2 1 1 1 1
) 1 (
~
t t t t t
u r c y c c r + + + =
1 3 2
*
1
) ( t t
*
t
0
~
1
=
+ t
f
t
y E
1 1
~
+
=
t t
e
t
y y E
S8
infoimation they unueistanu, anu uo not iequiie them to unueistanu the whole
pictuie.
Thus the specification of the heuiistics in (S.4) anu (S.S) shoulu not be
inteipieteu as a iealistic iepiesentation of how agents foiecast. Rathei is it a
paisimonious iepiesentation of a woilu wheie agents uo not know the Tiuth
(i.e. the unueilying mouel). The use of simple iules uoes not mean that the
agents aie uumb anu that they uo not want to leain fiom theii eiiois. I will
specify a leaining mechanism latei in this section in which these agents
continuously tiy to coiiect foi theii eiiois by switching fiom one iule to the
othei.
The maiket foiecast is obtaineu as a weighteu aveiage of these two foiecasts, i.e.

(S.6)

(S.7)

anu (S.8)

wheie anu aie the piobabilities that agents use a funuamentalist,
iespectively, an extiapolative iule.
A methouological issue aiises heie. The foiecasting iules (heuiistics) intiouuceu
heie aie not ueiiveu at the micio level anu then aggiegateu. Insteau, they aie
imposeu ex post, on the uemanu anu supply equations. This has also been the
appioach in the leaining liteiatuie pioneeieu by Evans anu Bonkapohja(2uu1).
Iueally one woulu like to ueiive the heuiistics fiom the miciolevel in an
enviionment in which agents expeiience cognitive pioblems. 0ui knowleuge
about how to mouel this behavioi at the micio level anu how to aggiegate it is
too sketchy, howevei. Psychologists anu biains scientists stiuggle to unueistanu
how oui biain piocesses infoimation. Theie is as yet no geneially accepteu
mouel we coulu use to mouel the miciofounuations of infoimation piocessing in
e
t t c t
f
t t f t t
E y E y E
~ ~ ~
, 1 , 1
o o + =
+ +
1 , , 1
0
~
+
+ =
t t c t f t t
y y E o o
1
, ,
= +
t e t f
o o
t f ,
o
t e,
o
S9
a woilu in which agents expeiience cognitive limitations. I have not tiieu to uo
so
7
.
Selectingtheforecastingrules
As inuicateu eailiei, agents in oui mouel aie not fools. They aie willing to leain,
i.e. they continuously evaluate theii foiecast peifoimance. This willingness to
leain anu to change ones behavioi is the most funuamental uefinition of iational
behavioi. Thus oui agents in the mouel aie iational, not in the sense of having
iational expectations. We have iejecteu the lattei because it is an implausible
assumption to make about the capacity of inuiviuuals to unueistanu the woilu.
Insteau oui agents aie iational in the sense that they leain fiom theii mistakes.
The concept of bounueu iationality is often useu to chaiacteiize this behavioi.
The fiist step in the analysis then consists in uefining a ciiteiion of success. This
will be the foiecast peifoimance of a paiticulai iule. Thus in this fiist step,
agents compute the foiecast peifoimance of the two uiffeient foiecasting iules
as follows:
(S.9)
(S.1u)
wheieU
f,t
anu U
e,t
aie the foiecast peifoimances (utilities) of the funuamentalist
anu extiapolating iules, iespectively. These aie uefineu as the mean squaieu
foiecasting eiiois (NSFEs) of the foiecasting iules; e
k
aie geometiically
ueclining weights. We make these weights ueclining because we assume that
agents tenu to foiget. Put uiffeiently, they give a lowei weight to eiiois maue fai
in the past as compaieu to eiiois maue iecently. The uegiee of foigetting will
tuin out to play a majoi iole in oui mouel.
The next step consists in evaluating these foiecast peifoimances (utilities). I
apply uisciete choice theoiy (see Anueison, ue Palma, anu Thisse, (1992) anu
Biock & Bommes(1997)) in specifying the pioceuuie agents follow in this
evaluation piocess. If agents weie puiely iational they woulu just compaie U
f,t


7
There are some attempts to provide micro-foundations of models with agents experiencing cognitive
limitations, though. See e.g. Kirman, (1992), Delli Gatti, et al.(2005).
U
f ,t
= e
k
k=0

y
t k1


E
f ,t k2
y
t k1
| |
2
U
e,t
= e
k
k=0

y
t k 1


E
e,t k 2
y
t k 1
| |
2
4u
anu U
e,t
in (S.9) anu (S.1u) anu choose the iule that piouuces the highest value.
Thus unuei puie iationality, agents woulu choose the funuamentalist iule if U
f,t
>
U
e,t
, anu vice veisa. Bowevei, things aie not so simple. Psychologists have founu
out that when we have to choose among alteinatives we aie also influenceu by
oui state of minu. The lattei is to a laige extent unpieuictable. It can be
influenceu by many things, the weathei, iecent emotional expeiiences, etc. 0ne
way to foimalize this is that the utilities of the two alteinatives have a
ueteiministic component (these aie U
f,t
anu U
e,t
in (S.9) anu (S.1u)) anu a ianuom
component c
f,t
anu c
e,t
The piobability of choosing the funuamentalist iule is then
given by
(S.11)
In woius, this means that the piobability of selecting the funuamentalist iule is
equal to the piobability that the stochastic utility associateu with using the
funuamentalist iule exceeus the stochastic utility of using an extiapolative iule.
In oiuei to ueiive a moie piecise expiession one has to specify the uistiibution
of the ianuom vaiiables c
f,t
anu c
e,t
. It is customaiy in the uisciete choice
liteiatuie to assume that these ianuom vaiiables aie logistically uistiibuteu (see
Anueison, Palma, anu Thisse(1992), p. SS). 0ne then obtains the following
expiessions foi the piobability of choosing the funuamentalist iule:

o
],t
=
cxp(y0
],t
)
cxp(y0
],t
)+cxp(y0
c,t
)
(S.12)

Similaily the piobability that an agent will use the extiapolative foiecasting iule
is given by:
o
c,t
=
cxp(y0
c,t
)
cxp(y0
],t
)+cxp(y0
c,t
)
= 1 - o
],t
(S.1S)

Equation (S.12) says that as the past foiecast peifoimance of the funuamentalist
iule impioves ielative to that of the extiapolative iule, agents aie moie likely to
select the funuamentalist iule foi theii foiecasts of the output gap. Equation
(S.1S) has a similai inteipietation. The paiametei measuies the intensity of
o
f ,t
= P U
f ,t
+c
f ,t
> (U
e,t
+c
e,t
| |
41
choice. It is ielateu to the vaiiance of the ianuom components c
f,t
anu c
e,t.
. If the
vaiiance is veiy high, appioaches 0. In that case agents ueciue to be
funuamentalist oi extiapolatoi by tossing a coin anu the piobability to be
funuamentalist (oi extiapolatoi) is exactly u.S. When = the vaiiance of the
ianuom components is zeio (utility is then fully ueteiministic) anu the
piobability of using a funuamentalist iule is eithei 1 oi u. The paiametei can
also be inteipieteu as expiessing a willingness to leain fiom past peifoimance.
When =0this willingness is zeio; it incieases with the size of .
Note that this selection mechanism is the uisciplining uevice intiouuceu in this
mouel on the kinu of iules of behavioi that aie acceptable. 0nly those iules that
pass the fitness test iemain in place. The otheis aie weeueu out. In contiast with
the uisciplining uevice implicit in iational expectations mouels, which implies
that agents have supeiioi cognitive capacities, we uo not have to make such an
assumption heie.
As aigueu eailiei, the selection mechanism useu shoulu be inteipieteu as a
leaining mechanism baseu on tiial anu eiioi. When obseiving that the iule
they use peifoims less well than the alteinative iule, agents aie willing to switch
to the moie peifoiming iule. Put uiffeiently, agents avoiu making systematic
mistakes by constantly being willing to leain fiom past mistakes anu to change
theii behavioi. This also ensuies that the maiket foiecasts aie unbiaseu.
The mechanism uiiving the selection of the iules intiouuces a selfoiganizing
uynamics in the mouel. It is a uynamics that is beyonu the capacity of any one
inuiviuual in the mouel to unueistanu. In this sense it is a bottomup system. It
contiasts with the mainstieam macioeconomic mouels in which it is assumeu
that some oi all agents can take a biius eye view anu unueistanu the whole
pictuie. These agents not only unueistanu the whole pictuie but also use this
whole pictuie to ueciue about theii optimal behavioi.

Heuristicsandselectionmechanisminforecastinginflation
Agents also have to foiecast inflation. A similai simple heuiistics is useu as in the
case of output gap foiecasting, with one iule that coulu be calleu a
42
funuamentalist iule anu the othei an extiapolative iule. (See Biaziei et al. (2uu6)
foi a similai setup). We assume an institutional setup in which the cential bank
announces an explicit inflation taiget. The funuamentalist iule then is baseu on
this announceu inflation taiget, i.e. agents using this iule have confiuence in the
cieuibility of this iule anu use it to foiecast inflation. Agents who uo not tiust
the announceu inflation taiget use the extiapolative iule, which consists
extiapolating inflation fiom the past into the futuie.
The funuamentalist iule will be calleu an inflation taigeting iule. It consists in
using the cential banks inflation taiget to foiecast futuie inflation, i.e.
(S.14)
wheie the inflation taiget is noimalizeu to be equal to u

The extiapolatois aie uefineu by

(S.1S)

The maiket foiecast is a weighteu aveiage of these two foiecasts, i.e.

(S.16)
oi

(S.17)

anu (S.18)

The same selection mechanism is useu as in the case of output foiecasting to
ueteimine the piobabilities of agents tiusting the inflation taiget anu those who
uo not tiust it anu ieveit to extiapolation of past inflation, i.e.

(S.19)

(S.2u)

wheie U
tar
,
t
anu U
ext,t
aie the foiecast peifoimances (utilities) associateu with the
use of the funuamentalist anu extiapolative iules. These aie uefineu in the same
way as in (S.9) anu (S.1u), i.e. they aie the negatives of the weighteu aveiages of
*
~
t =
tar
t
E
*
t
1 1 +
=
t t
ext
t
E t t
1 , 1 , 1
~ ~ ~
+ + +
+ =
t
ext
t t ext t
tar
t t tar t t
E E E t | t | t
1 ,
*
, 1
~
+
+ =
t t ext t tar t t
E t | t | t
1
, ,
= +
t ext t tar
| |
( )
) exp( ) exp(
exp
, ,
,
,
t ext t tar
t tar
t tar
U U
U


|
+
=
( )
) exp( ) exp(
exp
, ,
,
,
t ext t tar
t ext
t ext
U U
U


|
+
=
4S
past squaieu foiecast eiiois of using funuamentalist (inflation taigeting) anu
extiapolative iules, iespectively
This inflation foiecasting heuiistics can be inteipieteu as a pioceuuie of agents
to finu out how cieuible the cential banks inflation taigeting is. If this is veiy
cieuible, using the announceu inflation taiget will piouuce goou foiecasts anu as
a iesult, the piobability that agents will iely on the inflation taiget will be high. If
on the othei hanu the inflation taiget uoes not piouuce goou foiecasts
(compaieu to a simple extiapolation iule) the piobability that agents will use it
will be small.
Solvingthemodel
The solution of the mouel is founu by fiist substituting (S.S) into (S.1) anu
iewiiting in matiix notation. This yielus:


0i

AZ
t
= BF
t

Z
t+1
+ CZ
t-1
+ hr
t-1
+ u
t
(S.21)


wheie bolu chaiacteis iefei to matiices anu vectois. The solution foi Z
t
is given
by

Z
t
= A
-1
|BF
t

Z
t+1
+ CZ
t-1
+ hr
t-1
+ u
t
](S.22)

The solution exists if the matiix A is nonsingulai, i.e. if (1a
2
c
2
)a
2
b
2
c
1
0. The
system (S.22) uesciibes the solution foi y
t
anu t
t
given the foiecasts of y
t
anu t
t
.
The lattei have been specifieu in equations (S.4) to (S.12) anu can be substituteu
into (S.22). Finally, the solution foi r
t
is founu by substituting y
t
anu t
t
obtaineu
fiom (S.22) into (S.S).
The mouel has nonlineai featuies making it uifficult to aiiive at analytical
solutions. That is why we will use numeiical methous to analyze its uynamics. In
oiuei to uo so, we have to calibiate the mouel, i.e. to select numeiical values foi
the paiameteis of the mouel. In appenuix A the paiameteis useu in the
calibiation exeicise aie piesenteu. The mouel was calibiateu in such a way that
(

+
+
(

+
(

+
(

=
(

+
+
t t
t
t
t
t
t t
t t
t
t
u a
r
c a y a
b
y E
E
a a
b
y c a c a
b
c
q t
t
t
2
1
3 2 1
1
1
1
1
1
1 2
1
2 2 1 2
2
0
1 0
0 1
~
~
0
1
1
44
the time units can be consiueieu to be months. A sensitivity analysis of the main
iesults to changes in the some of the paiameteis of the mouel will be piesenteu.
The thiee shocks (uemanu shocks, supply shocks anu inteiest iate shocks) aie
inuepenuently anu iuentically uistiibuteu (i.i.u.) with stanuaiu ueviations of
u.S%.
3.3Animalspirits,learningandforgetfulness
In this section simulations of the behavioial mouel in the time uomain aie
piesenteu anu inteipieteu. The uppei panel of Figuie S.1 shows the time pattein
of output piouuceu by the behavioial mouel given a paiticulai iealization of the
stochastic i.i.u. shocks. A stiong cyclical movement in the output gap can be
obseiveu. The autocoiielation coefficient of the output gap is u.9S (which is veiy
close to u.94, i.e. the autocoiielation of the output gap in the 0S uuiing 196u
2uu9). The lowei panel of Figuie S.1 shows a vaiiable calleu animal spiiits. It
iepiesents the evolution of the piobabilities that agents extiapolate a positive
output gap. These piobabilities can also be inteipieteu as the fiaction of agents
using a positive extiapolation iule. Thus, when the piobability that agents
extiapolate a positive output gap is 1, we will say that the fiaction of agents
using this iule is 1. When in Figuie S.1 the cuive ieaches 1 all agents aie
extiapolating a positive output gap; when the cuive ieaches u no agents aie
extiapolating a positive output gap. In that case they all extiapolate a negative
output gap. Thus the cuive can also be inteipieteu as showing the uegiee of
optimism anu pessimism of agents who make foiecasts of the output gap.
The concept of animal spiiits has been intiouuceu by Keynes(19S6). Keynes
uefineu these as waves of optimism anu pessimism of investois that have a self
fulfilling piopeity anu that uiive the movements of investment anu output
8
. As a
iesult of the iational expectations ievolution, the notion that business cycle
movements can be uiiven by inuepenuent waves of optimism anu pessimism
was uiscaiueu fiom mainstieam macioeconomic thinking. Recently it has been
given a ieneweu acauemic iespectability by Akeilof anu Shillei(2uu9)
9
. 0ui

8
See Mario Nuti (2009)on the different interpretations of Animal Spirits. See also Farmer(2006).
9
There is an older literature trying to introduce the notion of animal spirits in macroeconomic models
that will be discussed in section 3.8.
4S
mouel gives a piecise uefinition of these animal spiiits. We now show how
impoitant these animal spiiits aie in shaping movements in the business cycle.
Combining the infoimation of the two panels in figuie S.1 it can be seen that the
mouel geneiates enuogenous waves of optimism anu pessimism (animal
spiiits). Buiing some peiious optimists (i.e. agents who extiapolate positive
output gaps) uominate anu this tianslates into above aveiage output giowth.
These optimistic peiious aie followeu by pessimistic ones when pessimists (i.e.
agents who extiapolate negative output gaps) uominate anu the giowth iate of
output is below aveiage. These waves of optimism anu pessimism aie essentially
unpieuictable. 0thei iealizations of the shocks (the stochastic teims in equations
(S.1) (S.S)) piouuce uiffeient cycles with the same geneial chaiacteiistics.
These enuogenously geneiateu cycles in output aie maue possible by a self
fulfilling mechanism that can be uesciibeu as follows. A seiies of ianuom shocks
cieates the possibility that one of the two foiecasting iules, say the extiapolating
one, has a highei peifoimance (utility), i.e. a lowei mean squaieu foiecast eiioi
(NSFE). This attiacts agents that weie using the funuamentalist iule. If the
successful extiapolation happens to be a positive extiapolation, moie agents will
stait extiapolating the positive output gap. The contagioneffect leaus to an
incieasing use of the optimistic extiapolation of the outputgap, which in tuin
stimulates aggiegate uemanu. 0ptimism is theiefoie selffulfilling. A boom is
cieateu.
Bow uoes a tuinaiounu aiise. Theie aie two mechanisms at woik. Fiist, theie
aie negative stochastic shocks that may tiiggei the tuinaiounu. Seconu, theie is
the application of the Tayloi iule by the cential bank. Buiing a boom, the output
gap becomes positive anu inflation oveishoots its taiget. This leaus the cential
bank to iaise the inteiest iate, theieby setting in motion a ieveise movement in
output gap anu inflation. This uynamics tenus to make a uent in the peifoimance
of the optimistic extiapolative foiecasts. Funuamentalist foiecasts may become
attiactive again, but it is equally possible that pessimistic extiapolation becomes
attiactive anu theiefoie fashionable again. The economy tuins aiounu.
These waves of optimism anu pessimism can be unueistoou to be seaiching
(leaining) mechanisms of agents who uo not fully unueistanu the unueilying
46
mouel but aie continuously seaiching foi the tiuth. An essential chaiacteiistic of
this seaiching mechanism is that it leaus to systematic coiielation in beliefs (e.g.
optimistic extiapolations oi pessimistic extiapolations). This systematic
coiielation is at the coie of the booms anu busts cieateu in the mouel. Note,
howevei, that when computeu ovei a significantly laige peiiou of time the
aveiage eiioi in the foiecasting goes to zeio. In this sense, the foiecast bias
tenus to uisappeai asymptotically.

Figure3.1:Outputgapinbehavioralmodel



The iesults conceining the time path of inflation aie shown in figuie S.2. Fiist
concentiate on the lowei panel of figuie S.2. This shows the fiaction of agents
using the extiapolatoi heuiistics, i.e. the agents who uo not tiust the inflation
taiget of the cential bank. 0ne can iuentify two iegimes. Theie is a iegime in


47
which the fiaction of extiapolatois fluctuates aiounu Su%, which also implies
that the fiaction of foiecasteis using the inflation taiget as theii guiue (the
inflation taigeteis) is aiounu Su%. This is sufficient to maintain the iate of
inflation within a naiiow banu of appioximately + anu 1% aiounu the cential
banks inflation taiget. Theie is a seconu iegime though which occuis when the
extiapolatois aie uominant. Buiing this iegime the iate of inflation fluctuates
significantly moie. Thus the inflation taigeting of the cential bank is fiagile. It
can be unueimineu when foiecasteis ueciue that ielying on past inflation
movements piouuces bettei foiecast peifoimances than ielying on the cential
banks inflation taiget. This can occui quite unpieuictably as a iesult of
stochastic shocks in supply anuoi uemanu. We will ietuin to the question of
how the cential can ieuuce this loss of cieuibility in chaptei S on optimal
monetaiy policy.

Figure3.2Inflationinbehavioralmodel

48
Conditionsforanimalspiritstoarise
The simulations iepoiteu in the pievious section assumeu a given set of
numeiical values of the paiameteis of the mouel (see appenuix). It was founu
that foi this set of paiametei values animal spiiits (measuieu by the movements
in the fiaction of optimistic extiapolatois) emeige anu affect the fluctuations of
the output gap. The coiielation coefficient between the fiaction of optimists anu
the output gap in the simulation iepoiteu in figuie S.1 is u.86. 0ne woulu like to
know how this coiielation evolves when one changes the paiametei values of
the mouel. I concentiate on two paiametei values heie, the intensity of choice
paiametei, , anu the memoiy agents have when calculating the peifoimance of
theii foiecasting. This sensitivity analysis will allow us to uetect unuei what
conuitions animal spiiits can aiise.

- Awillingnesstolearn
We fiist concentiate on the intensity of choice paiametei, . As will be
iemembeieu this is the paiametei that ueteimines the intensity with which
agents switch fiom one iule to the othei when the peifoimances of these iules
change. This paiametei is in tuin ielateu to the impoitance of the stochastic
component in the utility function of agents. When is zeio the switching
mechanism is puiely stochastic. In that case, agents ueciue about which iule to
apply by tossing a coin. They leain nothing fiom past mistakes. As incieases
they aie incieasingly sensitive to past peifoimance of the iule they use anu aie
theiefoie incieasingly willing to leain fiom past eiiois.
To check the impoitance of this paiametei in cieating animal spiiits we
simulateu the mouel foi consecutive values of staiting fiom zeio. Foi each
value of we computeu the coiielation between the animal spiiits anu the
output gap. We show the iesults of this exeicise in figuie S.S. 0n the hoiizontal
axis the consecutive values of (intensity of choice) aie piesenteu. 0n the
veitical axis the coiielation coefficient between output gap anu animal spiiits is
shown. We obtain a veiy inteiesting iesult. It can be seen that when is zeio (i.e.
the switching mechanism is puiely stochastic), this coiielation is zeio. The
49
inteipietation is that in an enviionment in which agents ueciue puiely ianuomly,
i.e. they uo not ieact to the peifoimance of theii foiecasting iule, theie aie no
systematic waves of optimism anu pessimism (animal spiiits) that can influence
the business cycle. When incieases, the coiielation incieases shaiply. Thus in
an enviionment in which agents leain fiom theii mistakes, animal spiiits aiise.
In othei woius, one neeus a minimum level of iationality (in the sense of a
willingness to leain) foi animal spiiits to emeige anu to influence the business
cycle. It appeais fiom figuie S.S that this is achieveu with ielatively low levels of
. Thus suipiisingly animal spiiits aiise not because agents aie iiiational. 0n the
contiaiy animal spiiits can only emeige if agents aie sufficiently iational.
Figure3.3Animalspiritsandlearning


- Acapacitytoforget
When agents test the peifoimance of the foiecasting iules they compute past
foiecasting eiiois. In uoing so, they apply weights to these past foiecast eiiois.
These weights aie iepiesenteu by the paiametei e
k
in equations (S.9)(S.1u).
We assume that these weights uecline as the past ieceues. In auuition, we
assume that these weights uecline exponentially. Let us uefine
(anu ). We can then iewiite equations (S.9) anu (S.1u) as follows (if you
uo not see this, tiy the ieveise, i.e. stait fiom (S.2S) anu (S.24), uo iepeateu
substitutions of U
ft1
,U
ft2
, etc., anu you then finu (S.9) anu (S.1u)):
k
k
e ) 1 ( =
1 0 s s
Su
(S.2S)
(S.24)
We can now inteipiet , as a measuie of the memoiy of agents. When = u
theie is no memoiy; i.e. only last peiious peifoimance matteis in evaluating a
foiecasting iule; when = 1 theie is infinite memoiy, i.e. all past eiiois,
howevei fai in the past, obtain the same weight. Since in this case theie aie
infinitely many peiious to iemembei, each peiiou ieceives the same u weight.
values of between u anu 1 ieflect some but impeifect memoiy. Take as an
example =0.6.This numbei implies that agents give a weight of u.4 to the last
obseiveu eiioi (in peiiou t1) anu a weight of u.6 to all the eiiois maue in
peiious beyonu the last peiiou.
We peifoimeu the same exeicise as in the pievious section anu computeu the
coiielation between animal spiiits anu the output gap foi consecutive values of
. The iesults aie shown in figuie S.4. It can be seen that when = 1 the
coiielation is zeio. This is the case wheie agents attach the same weight to all
past obseivations; howevei, fai in the past they occui. Put uiffeiently, when
agents have infinite memoiy; they foiget nothing. In that case animal spiiits uo
not occui. Thus one neeus some foigetfulness (which is a cognitive limitation) to
piouuce animal spiiits. Note that the uegiee of foigetfulness uoes not have to be
laige. Foi values of below u.98 the coiielations between output anu animal
spiiits aie quite high.
This anu the pievious iesults leau to an inteiesting insight. Animal spiiit emeige
when agents behave iationally (in the sense of a willingness to leain fiom
mistakes) anu when they expeiience cognitive limitations. They uo not emeige
in a woilu of eithei supeiiationality oi iiiationality.

| |
2
1 2 , 1 1 , ,
~
) 1 (

=
t t f t t f t f
y E y U U
| |
2
1 2 , 1 1 , ,
~
) 1 (

=
t t e t t e t e
y E y U U
S1
Figure3.4AnimalSpiritsandforgetting



3.4.Theworldisnonnormal

The existence of waves of optimism anu pessimism that have a selffulfilling
natuie has impoitant implications foi the natuie of the unceitainty in
macioeconomic mouels. Nainstieam macioeconomic anu finance mouels almost
univeisally piouuce movements in output anu asset piices that aie noimally
uistiibuteu. This was also maue cleai in chaptei 1. This is uue to the fact that in
these mainstieam mouels the shocks hitting the economy aie assumeu to be
noimally uistiibuteu. Since these mouels aie lineai these noimally uistiibuteu
shocks aie tianslateu into movements of output anu piices that aie also
noimally uistiibuteu
1u
.
We showeu in chaptei 1 that in the ieal woilu the movements in the output gap
aie not noimally uistiibuteu. (In chaptei 9, we will pioviue auuitional eviuence).
0ui behavioial macioeconomic mouel also piouuces movements of output that
aie not noimally uistiibuteu. We show this by piesenting the histogiam of the
output gaps obtaineu fiom a typical simulation like the one piouuceu in figuie
S.1. The iesult is piesenteu in figuie S.S. The fiequency uistiibution of the output
gap ueviates significantly fiom a noimal uistiibution. Theie is excess kuitosis
(kuitosis= 4.4) ,i.e. theie is too much concentiation of obseivations aiounu the

10
We discussed the procedure of introducing autocorrelated disturbances in DSGE-models in chapter
1. These models typically also produce normally distributed movements in output.
S2
mean foi the uistiibution to be noimal. In auuition theie aie fat tails. This means
that theie aie too many obseivations that aie extiemely small oi extiemely laige
to be compatible with a noimal uistiibution. Foi example, we count S
obseivations that exceeu five stanuaiu ueviations. In a noimal uistiibution
obseivations that ueviate fiom the mean by moie than S stanuaiu ueviations
have a chance of occuiience of one in 1.7 million obseivations. The fiequency
uistiibution in figuie S.S has 2uuu obseivations. Yet we finu S such obseivations.
0ne can concluue that the fiequency uistiibution of the output gap is not a
noimal uistiibution. We also applieu a moie foimal test of noimality, the }aique
Beia test, which iejecteu noimality. Note that the nonnoimality of the
uistiibution of the output gap is piouuceu enuogenously by the mouel, as we
feeu the mouel with noimally uistiibuteu shocks.
Figure3.5:Frequencydistributionofsimulatedoutputgap

Kuitosis=S.9, }aiqueBeia = 178.4 (pvalue = u.uu1)

This iesult is not without implications. It implies that when we use the
assumption of noimality in macioeconomic mouels we vastly unueiestimate the
piobability of laige changes. In this paiticulai case, the noimality assumption
tenus to unueiestimate the piobability that intense iecessions oi booms occui.
The same is tiue in finance mouels that assume noimality. These mouels
seiiously unueiestimate the piobability of extiemely laige asset piice changes.
In othei woius they unueiestimate the piobability of laige bubbles anu ciashes.
SS
To use the metaphoi intiouuceu by Nassim Taleb, theie aie many moie Black
Swans than theoietical mouels baseu on the noimality assumption pieuict.
It is fine to obseive this phenomenon. It is even bettei to have an explanation foi
it. 0ui mouel pioviues such an explanation. It is baseu on the paiticulai
uynamics of animal spiiits. We illustiate this in figuie S.6. This shows the
fiequency uistiibution of the animal spiiits inuex (uefineu eailiei) which is
associateu with the fiequency uistiibution of the output gap obtaineu in figuie
S.S. Fiom Figuie S.6 we obseive that theie is a concentiation of the animal
spiiits at the extieme values of u anu 1 anu also in the miuule of the uistiibution.
This featuie pioviues the key explanation of the nonnoimality of the
movements of the output gap.
When the animal spiiits inuex clusteis in the miuule of the uistiibution we have
tianquil peiious. Theie is no paiticulai optimism oi pessimism, anu agents use a
funuamentalist iule to foiecast the output gap. At iiiegulai inteivals, howevei,
the economy is giippeu by eithei a wave of optimism oi of pessimism. The
natuie of these waves is that beliefs get coiielateu. 0ptimism bieeus optimism;
pessimism bieeus pessimism. This can leau to situations wheie eveiybouy has
become eithei optimist of pessimist. These peiious aie chaiacteiizeu by extieme
positive of negative movements in the output gap (booms anu busts).
Figure3.6:Frequencydistributionsimulatedanimalspirits

S4
As mentioneu eailiei, the shocks in uemanu anu supply in oui behavioial mouel
aie noimally uistiibuteu. These noimally uistiibuteu shocks, howevei, aie
tiansfoimeu into nonnoimally uistiibuteu movements in the output gap. Thus
oui mouel explains nonnoimality; it uoes not assume it.
Fiom the pievious uiscussion it follows that oui behavioial macioeconomic
mouel has a stiong pieuiction about how the movements of the output gap aie
uistiibuteu. These movements shoulu be nonnoimal. We uiscusseu the eviuence
of nonnoimality of the uistiibution of the 0S output gap in the postwai peiiou in
chaptei 1, anu we concluueu theie that inueeu the ieallife uistiibution is
chaiacteiizeu by nonnoimality. We will spenu chaptei 9 uiscussing fuithei
empiiical eviuence foi the behavioial macioeconomic mouel.
Thus we can concluue that mouels that aie baseu on noimal uistiibutions will
tenu to unueiestimate the piobability that intense booms anu busts occui. Put
uiffeiently, oui behavioial mouel coiiectly pieuicts that laige swings in output
gap aie a iegulai featuie of ieality. This contiasts with mainstieam lineai
iational expectations mouels like the BSuEmouels uiscusseu in chaptei 1.

3.5Uncertaintyandrisk
Fiank Knight, a famous piofessoi of economics at the 0niveisity of Chicago
befoie the Seconu Woilu Wai intiouuceu the uistinction between iisk anu
unceitainty in his book Risk, 0nceitainty anu Piofits publisheu in 1921. Risk
accoiuing to Knight is quantifiable. It has to uo with events that have a
piobability of occuiience that can be iepiesenteu by a statistical uistiibution. As
a iesult, we can compute the piobability that these events occui with gieat
piecision. The ieason we can uo this is that theie is some iegulaiity in the
occuiience of these events anu lots of uata to uetect this iegulaiity. 0nceitainty
in contiast uoes not allow foi such quantification because of a lack of iegulaiity
anuoi an insufficiency of uata to uetect these iegulaiities.
The mainstieam macioeconomic mouels baseu on iational expectations
(incluuing the BSuEmouels) only allow foi iisk. In these mouels agents aie
capable of making piobabilistic statements about all futuie shocks baseu on
SS
quantifiable statistical uistiibutions obtaineu fiom the past. Thus in the BSuE
mouels agents know, foi example, that in any peiiou theie is a piobability of say
1u% that a negative supply shock of S% will occui. In fact they can tabulate the
piobability of all possible supply shocks, anu all possible uemanu shocks. This is
ceitainly an extiaoiuinaiy assumption.
The fiequency uistiibution of the output gap piesenteu in Figuie S.S suggests
that although the uistiibution is nonnoimal, theie is enough iegulaiity in the
uistiibution foi inuiviuual agents to use in oiuei to make piobabilistic
pieuictions. This iegulaiity, howevei, appeais only because of a laige amount of
peiious (2uuu) in the simulation exeicise. Assuming that one peiiou
coiiesponus to one month, we can see that the fiequency uistiibution is obtaineu
using 17u yeais of obseivations. In most uevelopeu countiies touay the
maximum amount of yeais about output gap uata is about 4u to Su yeais, a
quaitei of the amount of obseivations useu to constiuct the fiequency
uistiibution in Figuie S.S.
The question that aiises then is how ieliable aie fiequency uistiibutions of the
output gap obtaineu fiom much shoitei peiious. In oiuei to answei this question
we ian simulations of the behavioial mouel ovei shoit peiious (4uu,
coiiesponuing to appioximately 4u yeais). Foi each 4uupeiiou simulation we
computeu the fiequency uistiibution of the output gap. The iesult is piesenteu in
Figuie S.7. We obseive that the fiequency uistiibutions of the output gap
obtaineu in uiffeient 4uupeiiou simulations look veiy uiffeient. All exhibit
excess kuitosis but the uegiee of excess kuitosis vaiies a gieat ueal. In all cases
theie is eviuence of fat tails, but the exact shape vaiies a lot. In some 4uupeiiou
simulations theie aie only positive fat tails, in otheis only negative fat tails. In
still othei simulations fat tails appeai on both siues of the uistiibutions.
This suggests that if oui mouel of animal spiiits is the iight iepiesentation of the
ieal woilu obseivations ovei peiious of appioximately 4u yeais aie by fai
insufficient to uetect iegulaiities in the statistical uistiibutions of impoitant
vaiiables as the output gap that can be useu to make piobabilistic statements
about this vaiiable. Thus, oui behavioial mouel comes close to iepiesenting a
woilu in which unceitainty iathei than iisk pievails at the macioeconomic level.
S6
This contiasts with the stanuaiu iational expectations macioeconomic mouels in
which theie is only iisk anu no unceitainty.
Figure3.7:Frequencydistributionofoutputgapin400periodsimulations

3.6Credibilityofinflationtargetingandanimalspirits
In the pievious sections we iuentifieu the conuitions in which animal spiiits, i.e.
selffulfilling waves of optimism anu pessimism can aiise. We aigueu that when
animal spiiits pievail, unceitainty in the sense of Fiank Knight is cieateu. 0ui
implicit assumption was that the inflation taiget announceu by the cential bank
is not 1uu% cieuible. This impeifect cieuibility leaus agents to be skeptical anu
to continuously test the iesolve of the cential bank. We showeu that in such an
enviionment animal spiiits can aiise.
S7
In this chaptei we ask the following question. Suppose the inflation taiget can be
maue 1uu% cieuible. What uoes such a iegime imply foi the emeigence of
animal spiiits. We ask this question not because we believe that such a peifect
cieuibility can be achieveu, but iathei to analyze the conuitions unuei which
animal spiiits can aiise.
We analyze this question in the following way. Equations (S.14) anu (S.1S)
uefine the foiecasting iules agents use in an enviionment of impeifect
cieuibility. In such an enviionment, agents will occasionally be skeptical about
the announceu inflation taiget. In that case they cease to use the inflation taiget
to foiecast inflation anu ieveit to an extiapolative iule. In a peifectly cieuible
inflation taigeting iegime agents have no ieason to be skeptical anu will
theiefoie always use the announceu taiget as the basis foi theii foiecast. Thus in
peifectly cieuible iegime agents only use iule (S.14) anu theie is no switching.
The maiket foiecast of inflation (equation (S.17)) now simplifies to

anu the switching equations (S.19) anu (S.2u) uisappeai. The iest of the mouel is
unchangeu.
We simulateu this veision of the mouel using the same techniques as in the
pievious sections. We show some of the iesults in Figuie S.8 anu compaie them
with the iesults obtaineu in the iegime of impeifect cieuibility of inflation
taigeting analyzeu in the pievious section.
The contiast in the iesults is quite stiiking. When inflation taigeting is peifectly
cieuible animal spiiits aie weak. This can be seen fiom the fact that the animal
spiiits inuex uoes not show a concentiation of obseivations at the extieme
values of 1 (extieme optimism) anu u (extieme pessimism). This contiasts veiy
much with the impeifect cieuibility case. This uiffeience in occuiience of animal
spiiits has the effect of eliminating the fat tails in the fiequency uistiibution of
the output gap anu of inflation. In fact both uistiibutions aie now noimal with a
kuitosis aiounu S. The }aiqueBeia test cannot ieject the hypothesis that the
uistiibutions of output gap anu inflation aie noimal in the peifect cieuibility
*
1
~
t t =
+ t t
E
S8
case. The contiast with the uistiibutions obtaineu in the impeifect cieuibility
case is stiiking: these exhibit fat tails anu excess kuitosis.

Figure 3.8: Frequency distribution output gap and inflation, and animal
spirits
Peifect cieuibility Impeifect cieuibility




Thus when inflation taigeting is peifectly cieuible, peiious of intense booms anu
busts piouuceu by the existence of animal spiiits uo not occui. In auuition,
Knightian unceitainty is absent. The noimal uistiibution of output gap anu
inflation allows agents to make ieliable piobabilistic statements about these
S9
vaiiables. Wheie uoes this iesult come fiom. The answei is that when inflation
taigeting is peifectly cieuible, the cential bank uoes not have to caie about
inflation because inflation iemains close to the taiget most of the time. As a
iesult, the inteiest iate instiument can be useu to stabilize output most of the
time. Thus when animal spiiits aie optimistic anu tenu to cieate a boom, the
cential bank can kill the boom by iaising the inteiest iate. It can uo the opposite
when animal spiiits aie pessimistic. Put uiffeiently, in the case of peifect
cieuibility the cential bank is not put into a position wheie it has to choose
between inflation anu output stabilization. Inflation stability is achieveu
automatically. As a iesult, it can concentiate its attention on stabilizing output.
This then kills the animal spiiits.
A fully cieuible inflationtaigeting iegime piouuces wonueifully stabilizing
iesults on output anu inflation movements. Bow can a cential bank achieve such
a iegime of full cieuibility of its announceu inflation taiget. A spontaneous
answei is that this coulu be achieveu moie easily by a cential bank that only
focuses on stabilizing the iate of inflation anu stops woiiying about stabilizing
output. Thus by following a stiict inflation taigeting iegime a cential bank is, so
one may think, moie likely to ieach full cieuibility. We checkeu whethei this
conclusion is coiiect in the following way. We simulateu the mouel assuming
that the cential bank sets the output coefficient in the Tayloi iule equal to zeio.
Thus this cential bank uoes not caie at all about output stabilization anu only
focuses on the inflation taiget. Will such a cential bank, applying stiict inflation
taigeting, come close to full cieuibility. We show the iesult of simulating the
mouel unuei stiict inflation taigeting in Figuie S.9. The answei is immeuiately
eviuent. The fiequency uistiibution of output gap shows extieme ueviations
fiom the noimal uistiibution with veiy fat tails, suggesting laige booms anu
busts. Even moie iemaikably, we finu the same featuie in the fiequency
uistiibution of the iate of inflation that now shows laige ueviations fiom the
taiget (noimalizeu ate u). Thus stiict inflation taigeting uiamatically fails to
biing us closei to full inflation cieuibility. The ieason why this is so, is that the
powei of the animal spiiits is enhanceu. This can be seen by the miuule giaph in
Figuie S.9. We now see that most of the time the economy is giippeu by eithei
extieme optimism oi extieme pessimism. This tenus to uestabilize not only the
6u
output gap but also the iate of inflation. Thus, stiict inflation taigeting insteau of
biinging us closei to the niivana of peifect cieuibility moves us away fiom it. We
will come back to this issue in chaptei S wheie we analyze optimal monetaiy
policies in a behavioial macioeconomic mouel.

Figure3.9Frequencydistributionoutputgap,animalspiritsandinflation
withstrictinflationtargeting



61
3.7.Twodifferentbusinesscycletheories

The behavioial anu iational expectations macioeconomic mouels leau to veiy
uiffeient views on the natuie of business cycle. Business cycle movements in the
iational expectations (BSuE) mouels aiise as a iesult of exogenous shocks (in
piouuctivity, piefeiences, policy iegime) anu lags in the tiansmission of these
shocks to output anu inflation. Thus ineitia in output anu inflation aie the iesult
of the laggeu tiansmission of exogenous shocks. In auuition, as was pointeu out
in chaptei 1, BSuEmoueleis have ioutinely auueu autoiegiessive exogenous
shocks, theieby impoiting a uynamics that is not explaineu by the mouel. As a
iesult, one coulu call the business cycles intiouuceu in the BSuEmouel
exogenously cieateu phenomena.
In contiast, the behavioial mouel piesenteu heie is capable of geneiating ineitia,
anu business cycles, without imposing lags in the tiansmission piocess anu
without the neeu to impose autocoiielation in the eiioi teims. This coulu be
calleu enuogenous ineitia. This is shown by piesenting simulations of output anu
animal spiiits in the absence of lags in the tiansmission piocess in the uemanu
anu the supply equations. This is achieveu by setting the paiameteis of the
foiwaiulooking vaiiables a
1
= 1 in equation (S.1) anu b
1
= 1 in equation (S.2).
The iesults aie piesenteu in figuie S.1u. We obseive similai business cycle
movements in output that aie highly coiielateu to animal spiiits as in figuie S.1.
The coiielation between output anu animal spiiits now is u.71, which is
somewhat lowei than when lags in the tiansmission piocess weie assumeu
(figuie S.1). This coiielation, howevei, iemains significant anu is the main
uiiving foice behinu the output fluctuations.
The ineitia obtaineu in the behavioial mouel coulu also be calleu infoimational
ineitia. In contiast to the iational expectations mouel, agents in the behavioial
mouel expeiience an infoimational pioblem. They uo not fully unueistanu the
natuie neithei of the shock noi of its tiansmission. They tiy to unueistanu it by
applying a tiial anu eiioi leaining iule, but they nevei succeeu in fully
unueistanuing the complexity of the woilu. This cognitive pioblem then cieates
62
the ineitia in output anu piices. Thus one obtains veiy uiffeient theoiies of the
business cycles in the two mouels
11


Figure3.10:Outputgapandanimalspiritsinmodelwithoutlags





11
Ciitics of the heuiistic mouel piesenteu heie may aigue that the compaiison between the
iational anu the behavioial mouel is unfaii foi the iational mouel. Inueeu the heuiistic mouel
geneiates ineitia because the evaluation anu selection piocess of the uiffeient heuiistics is
backwaiu looking. This is the ieason why the behavioial mouel uoes not neeu lags in the
tiansmission piocess to geneiate ineitia. Bowevei, it can be aigueu that this evaluation anu
selection piocess can only be backwaiu looking, anu as a iesult, the lags that aie piesent in the
behavioial mouel aie within the logic of that mouel. This contiasts with the lags intiouuceu in
the iational mouel: they come fiom outsiue the mouel. See Nilani(2uu7b) who makes a similai
point contiasting iational expectations mouels with leaining mouels.

6S
3.8Animalspiritsinthemacroeconomicliterature
The behavioial mouel piesenteu in this section is not the fiist one to foimalize
the iuea of animal spiiits, i.e. expectations uiiven business cycle movements. In
fact theie is a veiy laige liteiatuie that has uone so in vaiious ways. In this
section we compaie oui appioach to these uiffeient stianus of the liteiatuie.
Theie is a fiist impoitant stianu of liteiatuie piouucing mouels with sunspot
equilibiia. This liteiatuie staiteu with Shell (1977) anu Azaiiauis (1981), anu
incluues Azaiiauis anu uuesneiie (1986). Nouels with sunspot equilibiia aie
founu both in the RBCfiamewoik (see Benhabib anu Faimei(1994) anu Faimei
anu uuo(1994) as in the NewKeynesian fiamewoik (Claiiua, uali anu ueitlei
(2uuu). In these mouels theie aie multiple RE solutions, which incluue self
fulfilling solutions that uepenu on extianeous vaiiables (sunspots). These
mouels pioviue foi a fully iational way to mouel animal spiiits, implementing
the basic insights of Keynes.
A veiy similai stianu of liteiatuie is pioviueu by mouels geneiating global
inueteiminacies. Bowitt anu NcAfee (1992), Evans, Bonkapohja anu Romei
(1998), anu Evans anu Bonkapohja (2uu1) uevelop mouels with exteinalities
that leau to multiple steauy states. These papeis exhibit equilibiia with ianuom
switching between high anu low activity steauy states (oi, in the Evans
BonkapohjaRomei papei, between high anu low giowth iates). The iational
expectations solutions in these mouels uepenu on an exogenous twostate
Naikov vaiiable that acts to cooiuinate expectations anu tiiggeis the shifts
between high (optimistic) anu low (pessimistic) states
12
.
The common chaiacteiistics of these multiple equilibiia mouels is an exogenous
piocess that leaus to switches between these uiffeient equilibiia. The mouel
piesenteu in the piesent papei uiffeis fiom these multiple equilibiia mouels in
that it uoes not iely on extianeous sunspots. The economic fluctuations aie
uiiven insteau by the intiinsic ianuom shocks of the mouel.

12
It should be noted that in each of these models fluctuations can also arise as the outcome of a
boundedly rational learning process
64
The lattei is also the case in EvansBonkapohja (2uu1, ch. 14) in which the
fluctuations aie uiiven by piouuctivity shocks, with the leaining iule leauing to
occasional shifts between equilibiia. Bowevei, oui mouel uiffeis fiom this anu
the pievious mouels in that it uoes not have multiple equilibiia unuei Rational
Expectations. Insteau, the multiplicity is the iesult of the iestiicteu list of
foiecast iules fiom which the agents can choose.
0ui mouel comes closest to Bianch anu Evans(2uu7) who also use a uisciete
choice fiamewoik insiue a simple monetaiy mouel anu who finu iegime
switching behavioi uiiven by the shocks in the mouel. The shifts in expectations,
as agents occasionally move fiom pooling on one foiecast iule to pooling on the
othei iule, is a kinu of selffulfilling phenomenon. The similaiity with oui mouel
is that in the Bianch anu Evans(2uu7) mouel theie is a unique equilibiium unuei
Rational Expectations, but because agents must choose between two
misspecifieu mouels, theie aie multiple equilibiia (of a type that the authois
caiefully uefine). 0nuei iealtime upuating of the uiscietechoice type, this leaus
to iegimeswitching behavioi ovei time. Bowevei, in BianchEvans(2uu7) the
switching is between high anu low volatility iegimes, wheieas in oui mouel it is
also between high anu low activity states, geneiating business cycle effects that
aie of fiist oiuei.

3.9Conclusion

In mainstieam Rational Expectations mouels laige uistuibances in output anu
piices only occui if theie aie laige exogenous shocks in uemanu anu supply oi in
the policy enviionment. Without these exogenous shocks iational anu supeibly
infoimeu agents peacefully optimize. They may have to wait a little to uo this
because of wage anu piice iigiuities (in NewKeynesian veisions of the classical
mouel) but they always satisfy theii uesiieu plan. 0nly toinauolike exteinal
shocks can uistuib this peaceful enviionment.
The mouel piesenteu in this chaptei is veiy uiffeient. It is capable of geneiating
laige movements in output (booms anu busts) without having to iely on laige
exogenous shocks. We assumeu thioughout this chaptei that the exogenous
6S
uistuibances aie noimally uistiibuteu. Yet the behavioial mouel is capable of
geneiating a statistical uistiibution of output movements that is not noimally
uistiibuteu anu that has fat tails. These aie laige movements in output that occui
with a highei piobability than the noimal uistiibution pieuicts.
The unueilying mechanism that piouuces these movements aie the waves of
optimism anu pessimism (animal spiiits) that aie geneiateu enuogenously anu
that have a selffulfilling piopeity. We founu that peiious of tianquility uuiing
which animal spiiits stay quiet aie followeu (unpieuictably) by peiious when
animal spiiits take ovei, i.e. laige movements of optimism oi pessimism leau
the economy in a peiiou of boom anu bust.
Thus oui behavioial mouel piouuces a theoiy of the business cycle that is veiy
uiffeient fiom the stanuaiu New Keynesian (BSuE) mouel. In the lattei mouel
the booms anu busts in output aie always the iesult of laige exogenous shocks.
In the BSuEwoilu, the financial ciisis that staiteu in August 2uu7 anu the
intense iecession that followeu it weie piouuceu by a suuuen exogenous shock
in 2uu7 that, as a toinauo, cieateu havoc in the financial maikets anu in the
macioeconomy. In fact, it is now stanuaiu piactice of BSuEmoueleis to simulate
the consequences of the financial ciisis on the economy by intiouucing an
exogenous inciease in iisk aveision (anu thus the iisk piemium)
1S
. In contiast
the behavioial mouel uevelopeu in this chaptei is capable of piouucing
enuogenous booms anu busts. This mouel leaus to the view that the bust of
2uu7u8 was the iesult of a boom geneiateu by excessive optimism piioi to that
uate.
Thioughout this chaptei we assumeu small anu noimally uistiibuteu shocks to
highlight the potential of the mouel to geneiate laige anu nonnoimally
uistiibuteu movements in output. In the ieal woilu laige exogenous shocks uo
occui. As a iesult, the movements in output anu piices will always be a mix of
inteinally geneiateu uynamics anu outsiue uistuibances. In the next chaptei we
theiefoie analyze how exteinal shock aie tiansmitteu in the behavioial mouel.

13
Interestingly, this is also the view of major bankers when they were questioned during hearings in
the US Congress in J anuary 2010. These bankers used metaphors such as a perfect storm and a
tornado to describe the causes of the financial crisis.
66
Appendix:Matlabcodebehavioralmodel
%% Parameters of the model
mm =1; %switching parameter gamma in Brock Hommes
pstar =0; % the central bank's inflation target
eprational=0; % if all agents have rational forecast of inflation this parameter is 1
epextrapol=0; % if all agents use inflation extrapolation this parameter is 1
a1 =0.5; %coefficient of expected output in output equation
a2 =-0.2; %a is the interest elasticity of output demand
b1 =0.5; %b1 is coefficient of expected inflation in inflation equation
b2 =0.05; %b2 is coefficient of output in inflation equation
c1 =1.5; %c1 is coefficient of inflation in Taylor equation
c2 =0.5; %c2 is coefficient of output in Taylor equation
c3 =0.5; %interest smoothing parameter in Taylor equation
A =[1 -b2;-a2*c1 1-a2*c2];
B =[b1 0;-a2 a1];
C =[1-b1 0;0 1-a1];
T =2000;
TI =250;
K =50; %length of period to compute divergence
sigma1 =0.5; %standard deviation shocks output
sigma2 =0.5; %standard deviation shocks inflation
sigma3 =0.5; %standard deviation shocks Taylor
rho=0.5; %rho in mean squares errors
rhoout=0.0; %rho in shocks output
rhoinf=0.0; %rho in shocks inflation
rhotayl=0.0; %rho in shocks Taylor
rhoBH=0.0;
epfs=pstar; %forecast inflation targeters
p =zeros(T,1);
y =zeros(T,1);
plagt =zeros(T,1);
ylagt =zeros(T,1);
r =zeros(T,1);
epf =zeros(T,1);
epc =zeros(T,1);
ep =zeros(T,1);
ey =zeros(T,1);
CRp =zeros(T,1);
FRp =zeros(T,1);
alfapt =zeros(T,1);
eyfunt =zeros(T,1);
CRy =zeros(T,1);
FRy =zeros(T,1);
alfayt =zeros(T,1);
anspirits =zeros(T,1);
epsilont =zeros(T,1);
etat =zeros(T,1);
ut =zeros(T,1);
%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%
%heuristic model
%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%
alfap=0.5;
alfay=0.5;
K1=K+1;
for t=2:T

epsilont(t) =rhoout*epsilont(t-1) +sigma1*randn; %shocks in output equation (demand shock)
etat(t)=rhoinf*etat(t-1) +sigma2*randn; %shocks in inflation equation (supply shock)
ut(t) =rhotayl*ut(t-1) +sigma3*randn; %shocks in Taylor rule (interest rate shock)
67
epsilon =epsilont(t);
eta =etat(t);
u =ut(t);
shocks =[eta;a2*u+epsilon];
epcs=p(t-1);
if eprational==1;
epcs=pstar;
end
eps=alfap*epcs+(1-alfap)*epfs;
if epextrapol==1;
eps=p(t-1);
end
eychar=y(t-1);
eyfun=0+randn/2;
eyfunt(t)=eyfun;
eys=alfay*eychar+(1-alfay)*eyfun;
forecast =[eps;eys];
plag=p(t-1);
ylag=y(t-1);
rlag=r(t-1);
lag =[plag;ylag];
smooth =[0;a2*c3];
D =B*forecast +C*lag +smooth*rlag +shocks;
X =A\D;
p(t)=X(1,1);
y(t)=X(2,1);
r(t)=c1*p(t)+c2*y(t)+c3*r(t-1)+u;
if square==1;
r(t)=c1*(p(t))^2+c2*y(t)+c3*r(t-1)+u;
end
plagt(t)=p(t-1);
ylagt(t)=y(t-1);
CRp(t) =rho*CRp(t-1) - (1-rho)*(epcs-p(t))^2;
FRp(t) =rho*FRp(t-1) - (1-rho)*(epfs-p(t))^2;
CRy(t) =rho*CRy(t-1) - (1-rho)*(eychar-y(t))^2;
FRy(t) =rho*FRy(t-1) - (1-rho)*(eyfun-y(t))^2;
alfap =rhoBH*alfapt(t-1)+(1-rhoBH)*exp(mm*CRp(t))/(exp(mm * CRp(t)) +exp(mm * FRp(t)));
alfay =rhoBH*alfayt(t-1)+(1-rhoBH)*exp(mm*CRy(t))/(exp(mm * CRy(t)) +exp(mm * FRy(t)));
alfapt(t) =alfap;
alfayt(t) =alfay;
if eychar>0;
anspirits(t)=alfay;
end
if eychar<0;
anspirits(t)=1-alfay;
end
end
autocory =corrcoef(y,ylagt);
autocorp =corrcoef(p,plagt);
coroutputanimal =corr(y,anspirits);
%% mean, median, max, min, standard deviation, kurtosis
Kurt =kurtosis(y);
%% jarque-bera test
[jb,pvalue,jbstat] =jbtest(y,0.05);

68

CHAPTER4:THETRANSMISSIONOFSHOCKS
69
4.1Introduction
The economy is continuously subjecteu to shocks. It is theiefoie impoitant to
finu out how these shocks aie tiansmitteu into the economy. We aigueu in the
pievious chaptei that in the mainstieam iational expectations macioeconomic
mouels only exteinal shocks mattei to explain movements in output anu
inflation. In oui behavioial mouel theie is an impoitant enuogenously geneiateu
uynamics explaining movements of output anu inflation. In this chaptei we
analyze how this enuogenous uynamics affects the tiansmission piocess of these
exogenous uistuibances. Biffeient shocks will be analyzeu. Fiist we will focus on
piouuctivity shocks; seconu on inteiest iate shocks, anu thiiu on fiscal policy
shocks.

4.2Thetransmissionofapositiveproductivityshock.
The way we analyze how a shock is tiansmitteu into the economy is to compute
the impulse iesponse functions. These uesciibe the path of one of the
enuogenous vaiiables (output gap, inflation) following the occuiience of the
shock. In oiuei to uo so we simulate two seiies of these enuogenous vaiiables.
0ne is the seiies without the shock (the baseline seiies); the othei is the seiies
with the shock. We then subtiact the fiist fiom the seconu one. This yielus a new
seiies, the impulse iesponse that shows how the enuogenous vaiiable that
embouies the shock evolves ielative to the benchmaik. These impulse iesponses
aie expiesseu as multiplieis, i.e. the output anu inflation iesponses to the
shock aie uiviueu by the shock itself (which is one stanuaiu ueviation of the
eiioi teim in the supply equation).
The behavioial mouel is nonlineai. Theiefoie uuiing the postshock peiiou we
continue to allow foi ianuom uistuibances. Thus the impulse iesponse measuies
the iesponse to the exogenous shock in an enviionment in which the ianuom
uistuibances aie the same foi the seiies with anu without the shock.
The exeicise was iepeateu Suu times with Suu uiffeient iealizations of the
ianuom uistuibances. The mean impulse iesponse togethei with the stanuaiu
ueviation was then computeu. We uefine the piouuctivity shock to be a one
7u
stanuaiu ueviation shock of the ianuom uistuibances of the aggiegate supply
equation. The iesults aie shown in figuie 4.1, which shows the mean iesponse
(full line) anu + anu 2 stanuaiu ueviations away fiom the mean (uotteu lines).
Note also that we intiouuceu the shock aftei 1uu peiious.

Figure4.1Meanimpulseresponsesofoutputgap,inflationandinterest
ratetopositiveproductivityshock




Fiom figuie 4.1 seveial conclusions can be ueiiveu. Fiist, the positive
piouuctivity shock has the expecteu macioeconomic effects. In the shoitteim
the output gap incieases anu inflation ueclines. In auuition, the inteiest iate
71
ueclines. This is so because the cential bank follows a Tayloi iule in which the
weight attacheu to inflation is much highei than the weight attacheu to the
output gap (the coefficient of inflation is 1.S while the coefficient of the output
gap is u.S). As a iesult the uecline in inflation leaus the cential bank to lowei the
inteiest iate so as to biing inflation back to its taiget. Seconu, in the long iun
these effects tenu to uisappeai. Note, howevei, that the level of output is
peimanently highei in the long iun equilibiium (because the piouuctivity shock
has iaiseu capacity output).
Thiiu, anu most impoitantly, theie is a wiue vaiiation in the shoitteim effects of
the piouuctivity shock. This can be seen fiom the fact that uotteu lines
iepiesenting + anu two stanuaiu ueviations fiom the mean aie veiy fai fiom
the mean. Thus it is veiy uifficult to pieuict how the same piouuctivity shock
affects the output gap anu inflation in the shoitiun. This unceitainty can also be
illustiateu by piesenting the fiequency uistiibution of the shoitteim output gap
anu inflation effects of the piouuctivity shock. We show these in figuie 4.2. We
have uefineu the shoitteim to mean the effect aftei six peiious (appioximately
half a yeai). The uiveigence in the effects of the same piouuctivity shock is
stiiking. It ianges foim +u.4% to 1.6% foi the output gap anu fiom u.1 to almost
1.S% foi inflation. We also note that the statistical uistiibution of these shoit
teim effects is fai fiom the noimal uistiibution anu exhibits fat tails. Thus the
same piouuctivity shock can leau to stiong outlying effects. The nonnoimal
uistiibution of the shoitteim effects auus to the unpieuictability of these effects.
Thus, the tiansmission of the shock is shiouueu by the veil of unceitainty (in the
sense of Fiank Knight).
Wheie uoes this unceitainty come fiom. Not fiom paiametei unceitainty. The
same paiameteis aie useu in constiucting all oui impulse iesponses. The answei
is that in this behavioial mouel each iealization of the shocks cieates uiffeient
waves of optimism anu pessimism (animal spiiits). 0ne coulu also call these
maiket sentiments. Thus a shock that occuis in one simulation happens in a
uiffeient maiket sentiment than the same shock in anothei simulation. In
auuition, the shock itself affects maiket sentiments. As a iesult, the shoitteim
effects of the same piouuctivity shock become veiy haiu to pieuict.
72

Figure4.2:Frequencydistributionofshorttermoutputgapandinflation
effectofproductivityshock


We show the impoitance of these maiket sentiments in Figuie 4.S. 0n the
hoiizontal axis we plot the mean value of the animal spiiits inuex up to the sixth
peiiou aftei the piouuctivity shock (iemembei that we uefineu the shoitteim
effect to be the effect six peiious aftei the shock). 0n the veitical axis the shoit
teim output anu inflation effects (iespectively) aie shown. Thus these figuies
show the ielation between maiket sentiments pievailing uuiing the aujustment
peiiou following the shock (incluuing the peiiou of the shock) anu the size of the
shoitteim effect of the piouuctivity shock. The most stiiking aspect of this
ielation is that animal spiiits mattei a gieat ueal foi the intensity of the effects of
a piouuctivity shock. This is veiy cleai fiom the lefthanu panel (iepiesenting
the output effect); less so fiom the iight hanu panel (iepiesenting the inflation
effect). We obseive that when theie aie no stiong optimistic oi pessimistic
maiket sentiments, the shoitteim output effect is on aveiage u.6; when the
maiket has tuineu into extieme optimism oi pessimism the same piouuctivity
shock has a shoitteim output effect that is about twice as high on aveiage,
i.e.1.2. Thus it appeais that animal spiiits amplify the shoitteim effects of a
given piouuctivity shock. When optimism pievails, a positive piouuctivity shock
cieates a much stiongei boom in the economy than in a neutial (animal spiiits
inuex = u.S). Similaily when pessimism pievails the positive piouuctivity shock
has a stiong positive output effect because it quickly enus the peiiou of
pessimism.
7S
Note, howevei, that the vaiiance aiounu the fitteu cuives is veiy laige. Thus
although maiket sentiments mattei, theie iemains a lot of unceitainty about its
effect in the tiansmission piocess.

Figure4.3:Effectsofproductivityshockdependonmarketsentiments



The iesults of the tiansmission of a piouuctivity shock in a behavioial mouel
contiast a gieat ueal with the iesults obtaineu in a stanuaiu iational
expectations mouel. In the lattei mouel theie is no unceitainty about the
tiansmission of a piouuctivity shock. If we know the paiameteis of the mouel we
can calculate the impulse iesponse function with exact piecision. It uoes not
uepenu at all on the piecise timing of the shock. The only unceitainty comes
fiom the unceitainty about the paiameteis of the mouel. But this unceitainty
also exists in a behavioial mouel. Thus, the mainstieam iational expectations
mouel cieates the illusion of excessive piecision. If we have a lot of piecise
knowleuge about the paiameteis of the mouel, we also have a lot of piecision
about the tiansmission of an exogenous shock. But this may not be the case if as
in oui behavioial mouel the existence of animal spiiits (maiket sentiments)
cieates gieat unceitainty about this tiansmission.

74
4.3Thetransmissionofinterestrateshocks
In this section we focus on the question of how an inteiest iate shock is
tiansmitteu in the economy. We use the same techniques as in the pievious
section, i.e. we compute the impulse iesponses to a positive inteiest iate shock,
uefineu as an inciease in the inteiest iate equal to one stanuaiu ueviation of the
ianuom uistuibances in the Tayloi equation. We show the iesults in Figuies 4.4
anu 4.S.
The impulse iesponse functions (Fig 4.4) anu the fiequency uistiibutions of the
shoitteim effects (Fig 4.S) weie computeu in the same way as in the pievious
section. We concentiate on the impulse iesponse functions fiist. We finu the
tiauitional iesult conceining the effects of an inciease in the inteiest iate. The
output gap anu the iate of inflation uecline following the inciease in the inteiest
iate. The uecline in output, howevei, is swiftei anu moie intense than the uecline
in the iate of inflation. This has to uo with the builtin wage anu piice iigiuities in
the mouel.
As in the pievious section we finu consiueiable unceitainty about the shoitteim
tiansmission of the inteiest iate inciease. This can be seen both fiom the wiue
banu of unceitainty aiounu the mean impulse iesponse in figuie 4.4 anu the
fiequency uistiibution of the shoitteim effects (figuie 4.S). The lattei aie not
noimally uistiibuteu anu exhibit fat tails. The iiiegulai natuie of these
fiequency uistiibutions (uespite the fact that we peifoimeu 1uuu uiffeient
calculations of impulse iesponses) suggests that it will be veiy uifficult to make
piecise piobabilistic statements about the shoitteim output anu inflation effects
of an inteiest iate shock.
As befoie this unceitainty uoes not come fiom paiametei unceitainty. The same
paiameteis aie useu in constiucting all oui impulse iesponses. The unceitainty
comes fiom the fact in this behavioial mouel each iealization of the shocks
cieates uiffeient waves of optimism anu pessimism (animal spiiits) that affect
the tiansmission of the inteiest iate shock. This kinu of unceitainty is absent
fiom stanuaiu iational expectations macioeconomic mouels. In these mouels we
7S
know the tiansmission of monetaiy policy with piecision if the paiameteis of the
mouel aie known with piecision.

Figure4.4:Impulseresponsetopositiveinterestrateshock

Figure4.5:Frequencydistributionofshorttermeffectsinterestrateshock

Kuitosis = S.7
76
The behavioial mouel contiasts with the stanuaiu New Keynesian in that in the
foimei the timing of the shock matteis. The same shocks applieu at uiffeient
times can have veiy uiffeient shoitteim effects on inflation anu output. In othei
woius, histoiy matteis. This is not the case in the stanuaiu New Keynesian
mouel: the same inteiest iate shock has always has the same effect whatevei the
timing of the shock.
Note that the unceitainty about the impulse iesponses tenus to uisappeai in the
long iun, as the effect of shoitteim uiffeiences in maiket sentiments uisappeais.
Finally we also analyzeu the question of how the tiansmission of the inteiest iate
shock is influenceu by the maiket sentiments (animal spiiits). We use the same
pioceuuie as in the pievious section. This yielus Figuie 4.6. 0n the hoiizontal
axis the animal spiiits inuex is shown. As befoie, it vaiies between u anu 1. When
the inuex is zeio all agents aie extiapolating a negative output gap, i.e.
pessimism is at the highest level. When the inuex is one alls agents extiapolate a
positive output gap. 0ptimism is at its peak. When the inuex is equal to u.S few
agents aie in fact extiapolating, anu most aie following a funuamentalists iule,
i.e. they expect the output gap to ietuin to zeio (its steauy state value). 0n the
veitical axes of figuie 4.6 the shoitteim output effect anu the shoitteim
inflation effect (iespectively) of an inteiest iate inciease aie shown.

Figure4.6:Effectsofmonetarypolicydependonmarketsentiments


The iesults of figuie 4.6 lenu themselves to the following inteipietation. Fiist,
animal spiiits have a stiong impact on the shoitteim output effect of the same
inteiest iate shock. In geneial, the stiongei the animal spiiits, i.e. the stiongei
77
optimism anu pessimism aie, the gieatei is the shoitteim impact of the inteiest
iate shock on output. In contiast, when animal spiiits aie weak (the inuex is
close to u.S) the impact is weakest. Thus, when the maiket is uominateu by
eithei optimism oi pessimism, the monetaiy authoiities inteiest iate
instiument has the gieatest impact on output (in the shoit iun). Like in the case
of a piouuctivity shock animal spiiits tenu to amplify the shoitteim effects of
monetaiy policies. These effects, howevei, tenu to uisappeai in the long iun.
Seconu, the animal spiiits have a much lowei impact on the effectiveness of
monetaiy policy to move inflation. This is maue cleai fiom contiasting the two
giaphs in figuie 4.6, which shows a low sensitivity of animal spiiits on the impact
of an inteiest iate shock on inflation.

4.4Fiscalpolicymultipliers:Howmuchdoweknow?
Since the eiuption of the financial ciisis in 2uu7u8 goveinments of majoi
countiies have applieu massive policies of fiscal stimulus. This has leu to a
heateu uebate about the size of the fiscal policy multiplieis. This uebate has
ievealeu (once moie) how uiveigent economists views aie about the size of
these multiplieis (see Wielanu, at al. (2uu9)). The estimates of the shoitteim
multiplieis vaiy fiom u to numbeis fai exceeuing 1. Theie has been a lot of soul
seaiching about the ieasons of these wiuely uiveigent estimates.
An impoitant souice of these uiffeiences is to be founu in the use of uiffeient
mouels that embouy uiffeient piiois. Foi example, in mainstieam
macioeconomic mouels that incoipoiate agents with iational expectations (both
New Classical anu the New Keynesian) fiscal policy multiplieis aie likely to be
veiy small as these mouels typically have Ricaiuian equivalence embeuueu in the
mouel, i.e. agents anticipating futuie tax incieases following a fiscal stimulus
(buuget ueficit) will stait saving moie (consuming less) so that one uollai of
goveinment spenuing is offset by 1 uollai of less piivate spenuing. In these
mouels the fiscal policy multipliei is close to zeio. In Keynesian mouels theie is
scope foi a net stimulatoiy effect of fiscal policies. Thus, the uiffeient estimates
78
of fiscal policy multiplieis aie not neutial estimates but ieflect theoietical
piiois anu beliefs that have been put in these mouels in the constiuction stage.
0ui behavioial mouel allows us to sheu some auuitional light on the unceitainty
suiiounuing the effects of fiscal policies. We will uo this by stuuying how a
positive shock in aggiegate uemanu piouuceu by a fiscal expansion affects
output. We will not give an exhaustive analysis of fiscal policies. 0ui mouel uoes
not give sufficient uetail of goveinment spenuing anu taxation to be able to uo
this. We mouel a fiscal policy shock just as a shock in the uemanu equation. What
the mouel allows us to establish is the natuie of unceitainty suiiounuing such a
shock even in an extiemely simple mouel.
We assume the fiscal policy expansion to occui unuei two uiffeient monetaiy
policy iegimes. In the fiist iegime we assume that the cential bank uses the
stanuaiu Tayloi iule as specifieu in equation (S). Thus unuei this iegime the
fiscal policy expansion will automatically leau the cential bank to iaise the
inteiest iate. This follows fiom the fact that the uemanu stimulus piouuces an
inciease in output anu inflation to which the cential bank ieacts by iaising the
inteiest iate.
In the seconu iegime we assume that the cential bank uoes not ieact to the
stimulus inuuceu expansion of output anu inflation by iaising the inteiest iate.
We uo this, not because it is iealistic, but iathei to estimate the puie Keynesian
multipliei effect of a fiscal stimulus. The Keynesian multipliei is usually
estimateu unuei the assumption of a constant inteiest iate so that ciowuing out
uoes not occui.
We show the iesults of this fiscal policy stimulus unuei the two monetaiy policy
iegimes in Figuie 4.7. The uppei two panels show the impulse iesponses unuei
the two monetaiy policy iegimes. The instantaneous effects of the fiscal stimulus
aie the same unuei the two iegimes. Bowevei, unuei the vaiiable inteiest iate
iegime the positive effects of the fiscal stimulus uecline much fastei anu
unueishoot in the negative iegion moie than unuei the constant inteiest iegime.
This is not suipiising as unuei the vaiiable inteiest iate iegime we see that the
inteiest iate is iaiseu quite substantially (see bottom panel), leauing to a quick
ciowuing out.
79
A seconu impoitant uiffeience conceins the uegiee of unceitainty about the size
of the output effects of a fiscal stimulus. As the uppei panels shows the
uiveigence of the impulse iesponses aie much laigei in the constant inteiest iate
iegime than in the vaiiable inteiest iate iegime. This is also illustiateu in the
seconu panels. These show the fiequency uistiibution of the shoitteim output
iesponses unuei the two iegimes. We obseive a much wiuei spieau of these
shoitteim output iesponses unuei the fixeu inteiest iate iegime. The ieason is
founu in the thiiu panels. These show that the shoitteim output iesponses aie
moie sensitive to animal spiiits in the fixeu inteiest iate iegime than in the
vaiiable one. Thus the inteiest iate iesponse unuei the vaiiable inteiest iate
iegime tenus to ieuuce the impact of animal spiiits on the tiansmission
mechanism, theieby ieuucing the volatility in this tiansmission. Put uiffeiently,
when as a iesult of the fiscal expansion the cential bank iaises the inteiest iate,
it loweis the expansionaiy effect of this expansion, making it less likely that
positive animal spiiits will enhance the fiscal policy stimulus.
These iesults make cleai that theie is likely to be a gieat amount of unceitainty
about the size of the output effects of fiscal policies. This unceitainty is even
moie pionounceu in the Keynesian scenaiio of constant inteiest iate. This is also
the scenaiio usually associateu with the occuiience of a liquiuity tiap (a
hoiizontal LNcuive). This is the assumption that tenus to make fiscal policies
most effective. In oui mouel it is also the assumption making the unceitainty
about the size of these effects the gieatest.

8u
Figure4.7:Impulseresponsesofoutputafterfiscalexpansion
Constant inteiest iate vaiiable inteiest iate






81
These uiffeiences aie also maue cleai fiom a compaiison of the longteim fiscal
policy multiplieis obtaineu fiom the same simulations as in Figuie 4.7. The fiscal
policy shock unueilying the pievious simulations is a onepeiiou inciease in
uemanu (by one stanuaiu ueviation). (The closest example of such a shock is the
Cash foi Clunkeis cai buying stimulus piogiams intiouuceu in many Euiopean
countiies anu in the 0S in 2uu9). This tempoiaiy inciease then piouuces the
impulse iesponses as given in figuie 4.7. In oiuei to obtain the longteim
multiplieis we auu up all the output incieases (anu ueclines) following this
tempoiaiy fiscal policy shock. We show these longteim fiscal policy multiplieis
in Figuie 4.8 unuei the two monetaiy policy iegimes.
Two iesults stanu out. Fiist, as expecteu, the longteim fiscal policy multiplieis
aie much highei unuei the constant inteiest iate iule than unuei the vaiiable
inteiest iate iule. Seconu, the unceitainty suiiounuing these longteim
multiplieis is consiueiable. Anu this unceitainty is the most pionounceu unuei
the constant inteiest iate iule.
It shoulu be stiesseu again that the natuie of the unceitainty heie is not the
unceitainty suiiounuing the paiameteis of the mouel. We assume exactly the
same paiameteis in all these simulations. Put uiffeiently, it is not the unceitainty
piouuceu by the use of uiffeient mouels with uiffeient piioi beliefs about the
effectiveness of fiscal policies that piouuce unceitainty. The unceitainty is uue to
uiffeiences in initial conuitions (maiket sentiments). These uiffeiences in maiket
sentiments have a pionounceu effect on how the same fiscal policy shock is
tiansmitteu in the economy.





82
Figure4.8:Longtermfiscalpolicymultipliers:Frequencydistribution

vaiiable inteiest iate Constant inteiest iate

4.5Transmissionunderperfectcredibilityofinflationtarget

In the pievious chaptei we founu that the occuiience of animal spiiits also
uepenus on the monetaiy iegime. In paiticulai, we founu that when the inflation
taigeting iegime is peifectly cieuible, the powei of animal spiiits to shape the
business cycle is gieatly uiminisheu. This iaises the question of whethei a
peifectly cieuible inflationtaigeting iegime may not also gieatly affect the
tiansmission of shocks.
We analyze this question by computing the impulse iesponses to exogenous
shocks unuei the assumption that peifect cieuibility of inflation taigeting
pievails. The pioceuuie is the same as in the pievious section. We fiist show the
impulse iesponses to a positive piouuctivity shock. The iesults aie shown in
Figuie 4.9. The contiast with the impulse iesponses obtaineu unuei impeifect
cieuibility (which aie the same impulse iesponses as in Figuie 4.1) is stiiking.
We finu thiee impoitant uiffeiences. Fiist the shoitteim impact of the
piouuctivity shock on output is gieatly ieuuceu in a iegime of peifect cieuibility.
This has to uo with the fact that in the absence of animal spiiits the amplification
effect of exogenous shocks uisappeais. Seconu, unuei peifect cieuibility the time
it takes foi the enuogenous vaiiables (output gap, inflation, inteiest iate) to
ietuin to theii longteim values is much shoitei than unuei impeifect
cieuibility. Thiiu, unuei peifect cieuibility, the unceitainty suiiounuing the
shoitteim effects of the exogenous shocks is gieatly ieuuceu. Fiom Figuie 4.9
8S
we obseive that the impulse iesponse path is much moie piecise (much lowei
stanuaiu ueviations) in the peifect cieuibility iegime than in the impeifect
cieuibility one. As a iesult, in an enviionment of peifectly cieuible inflation
taigeting the effects of an exogenous shock can be pieuicteu with much gieatei
piecision than in a iegime of impeifectly cieuible inflation taigeting. In such a
monetaiy iegime the Knightian unceitainty is much less pievalent anu we ietuin
to the woilu of quantifiable iisk.
The impulse iesponses obtaineu unuei peifect cieuibility of inflation taigeting
come veiy close to the impulse iesponses obtaineu in the iational expectations
veision of the mouel. We showeu these impulse iesponses in chaptei 2, anu
stiesseu that in this mouel theie is no unceitainty about the tiansmission of
shocks (pioviueu we know the paiameteis of the mouel).
84
Figure4.9:Impulseresponsestoapositiveproductivityshock
Perfectcredibility Imperfectcredibility

8S


















CHAPTER5:OPTIMALMONETARYPOLICY









86
5.1Introduction
Nouein macioeconomics in geneial anu BSuEmouels in paiticulai, have
pioviueu the intellectual founuation of inflation taigeting. 0ntil the eiuption of
the financial ciisis in 2uu7, inflation taigeting stiategies hau become the
unuisputeu policy fiamewoik mouein cential banks shoulu auopt. Anu most uiu.
The official holueis of macioeconomic wisuom ueclaieu that this step towaius
inflation taigeting constituteu a gieat victoiy of macioeconomics as a science
(Wooufoiu(2uu9)). Fiom now on we woulu be living in a moie stable
macioeconomic enviionment, a uieat Noueiation. Bow things can change so
quickly.
Inflation taigeting, of couise, uoes not imply that theie is no iole foi output
stabilization. As we stiesseu in chaptei 1, New Keynesian BSuEmoueleis have
always stiesseu that wage anu piice iigiuities pioviue a iationale foi output
stabilization by cential banks (see Claiiua, et al(1999), uali(2uu8)). This iuea has
founu its ieflection in flexible inflation taigeting (Svensson(1997),
Wooufoiu(2uu2)). Because of the existence of iigiuities, a cential bank shoulu
not attempt to keep inflation close to its taiget all the time. When sufficiently
laige shocks occui that leau to uepaituies of inflation fiom its taiget, the cential
bank shoulu follow a stiategy of giauual ietuin of inflation to its taiget. The
iationale is that in a woilu of wage anu piice iigiuities too abiupt attempts to
biing back inflation to its taiget woulu iequiie such high incieases in the inteiest
iate as to piouuce too stiong ueclines in output.
0utput stabilization in the BSuEwoilu, howevei, is veiy much ciicumsciibeu.
The neeu to stabilize output aiises because of the existence of iigiuities in piices
that makes it necessaiy to spieau out piice movements ovei longei peiious. The
limiteu scope foi output stabilization is baseu on a mouel chaiacteiizeu by a
stable equilibiium. Theie is no consiueiation of the possibility that the
equilibiium may be unstable oi that fluctuations in output have a uiffeient oiigin
than piice iigiuities. Shoulu the scope foi output stabilization be enlaigeu. This
is the question we tiy to answei in this chaptei. In oiuei to sheu some light on
87
this issue we ueiive the tiaueoff between output anu inflation vaiiability in the
context of oui behavioial mouel, anu we foimulate some policy conclusions.
5.2Constructingtradeoffs
The tiaueoffs between output anu inflation vaiiability aie constiucteu in the
same way as was uone in chaptei 1. The mouel was simulateu 1u,uuu times anu
the aveiage output anu inflation vaiiability weie computeu foi uiffeient values
of the Tayloi iule paiameteis. Figuie S.1 shows how output vaiiability (panel a)
anu inflation vaiiability (panel b) change as the output coefficient (c
2
) in the
Tayloi iule incieases fiom u to 1. Each line iepiesents the outcome foi uiffeient
values of the inflation coefficient (c
1
) in the Tayloi iule.
Panel a showing the evolution of output vaiiability exhibits the expecteu iesult,
i.e. as the output coefficient (c
2
) incieases (inflation taigeting becomes less
stiict) output vaiiability tenus to ueciease. 0ne woulu now expect that this
uecline in output vaiiability iesulting fiom moie active stabilization comes at the
cost of moie inflation vaiiability. This is what we founu in the New Keynesian
mouel of Chaptei 1 (see Figuie 1.2). This, howevei, is not founu in panel b. 0ne
obseives that the ielationship is nonlineai. As the output coefficient is incieaseu
fiom zeio, inflation vaiiability fiist ueclines. 0nly when the output coefficient
incieases beyonu a ceitain value (in a iange u.6u.8) inflation vaiiability staits
incieasing. Thus the cential bank can ieuuce both output anu inflation vaiiability
when it moves away fiom stiict inflation taigeting (c
2
=u) anu engages in some
output stabilization. Not too much though. Too much output stabilization tuins
aiounu the ielationship anu incieases inflation vaiiability.
Figuie S.1 allows us to constiuct the tiaueoffs between output anu inflation
vaiiability. These aie shown in figuie S.2 foi uiffeient values of the inflation
paiametei c
1
. Take the tiaueoff AB. This is the one obtaineu foi c
1
=1. Stait fiom
point A on the tiaueoff. In point A, the output paiametei c
2
=u (stiict inflation
taigeting). As output stabilization incieases we fiist move uownwaius. Thus
incieaseu output stabilization by the cential bank ieuuces output anu inflation
vaiiability. The ielation is nonlineai, howevei. At some point, with too high an
output stabilization paiametei, the tiaueoff cuive staits incieasing, becoming a
88
noimal tiaueoff, i.e. a lowei output vaiiability is obtaineu at the cost of
incieaseu inflation vaiiability.

Figure5.1:Outputandinflationvariability
Panela

Panelb


89
Figure5.2:Tradeoffsinthebehavioralmodel


Bow can we inteipiet these iesults. Let us stait fiom the case of stiict inflation
taigeting, i.e. the authoiities set c
2
=u. Theie is no attempt at stabilizing output at
all. The ensuing output vaiiability intensifies the waves of optimism anu
pessimism (animal spiiits), which in tuin feeu back on output volatility. These
laige waves leau to highei inflation vaiiability. Thus, some output stabilization is
goou; it ieuuces both output anu inflation vaiiability by pieventing too laige
swings in animal spiiits. With no output stabilization at all (c
2
=u) the foices of
animal spiiits aie so high that the high output vaiiability also incieases inflation
volatility thiough the effect of the output gap on inflation (supply equation). Too
much output stabilization, howevei, ieuuces the stabilization bonus pioviueu by
a cieuible inflation taiget. When the cential bank attaches too much impoitance
to output stabilization it cieates moie scope foi bettei foiecasting peifoimance
of the inflation extiapolatois, leauing to moie inflation vaiiability.
Figuie S.2 also tells us something impoitant about inflation taigeting. We note
that incieasing the inflation paiametei in the Tayloi iule (c
1
) has the effect of
shifting the tiaueoffs uownwaius, i.e. the cential bank can impiove the tiaueoffs
A
B
9u
by ieacting moie stiongly to changes in inflation
14
. The cential bank achieves
this impiovement in the tiaueoff because by ieacting moie intensely to changes
in inflation it ieuuces the piobability that inflation extiapolatois will tenu to
uominate the maiket, anu as a iesult it ieuuces the piobability that inflation
taigeting looses cieuibility. Such a loss of cieuibility uestabilizes both inflation
anu output. Thus maintaining cieuibility of inflation taigeting is an impoitant
souice of macioeconomic stability in oui behavioial mouel.
Note that the uownwaiu movements of the tiaueoffs tenu to slow uown with
incieasing values of the inflation paiametei in the Tayloi iule (c
1
). Auuitional
simulations show that when c
1
ieaches the value of 6, fuithei incieases in this
paiametei have impeiceptible effects on the tiaueoffs. In othei woius the tiaue
offs conveige to a stable position. The minimum point on this tiaueoff then
iepiesents the best possible outcome foi a cential bank, which focuses on
minimizing the vaiiability of inflation. It is the best possible point foi a cential
bank that only caies about inflation. The inteiesting implication is that the
cential bank can only achieve this point if it actively tiies to stabilize output.
The pievious iesults suggest that theie is a ielationship between the paiameteis
c
1
anu c
2
in the Tayloi equation anu the cieuibility of the inflation taiget. This
ielationship can be analyzeu in moie uetail. Inflation cieuibility can be given a
piecise uefinition in the mouel. It can be uefineu as the fiaction of agents who
use the inflation taiget to foiecast inflation (inflation taigeteis). Thus when
moie agents use the announceu inflation taiget to foiecast inflation, cieuibility
incieases. Figuie S.S piesents the ielationship between inflation cieuibility anu
the paiameteis c
1
anu c
2
. 0n the hoiizontal axis the paiametei c
2
(output
paiametei) is set out; on the veitical axis the inflation cieuibility. The lattei is
obtaineu by simulating the mouel 1u,uuu times anu computing the mean
fiactions of inflation taigeteis foi uiffeient values of the c
1
anu c
2
. Each cuive
iepiesents the ielation between cieuibility anu the output paiametei (c
2
) foi
uiffeient values of the inflation paiametei (c
1
). It has a nonlineai featuie, i.e.
when the output paiametei c
2
incieases this has the effect of fiist incieasing
inflation cieuibility until a maximum is ieacheu. Then cieuibility staits ueclining

14
A similar result on the importance of strict inflation is also found in Gaspar, Smets and
Vestin(2006) who use a macromodel with statistical learning.
91
when c
2
incieases fuithei. This nonlineai featuie is founu foi all values of c
1
.
Note that the maximum points obtaineu in figuie S.S coiiesponu to the minimum
point of the tiaueoffs in figuie S.2.
These iesults have the following inteipietation. When the cential bank incieases
its effoit to stabilize output this has at fiist a positive effect on the cieuibility of
its inflation taiget. The ieason, as was uiscusseu eailiei, is that by stabilizing
output, the cential bank also ieuuces the amplituue of the waves of optimism
anu pessimism (animal spiiits) theieby stabilizing output anu inflation. Inflation
cieuibility is maximizeu when c
2
is in a iange between u.S anu 1. Beyonu that
iange fuithei attempts to stabilize output ieuuce inflation cieuibility foi the
ieasons given eailiei. The inteiesting aspect of this iesult is that the optimal
values of c
2
aie in a iange often founu in econometiic stuuies of the Tayloi
equation. Thus cential banks seem to apply a uegiee of output stabilization that
is consistent with oui theoiy of animal spiiits.

Figure5.3:Inflationcredibilityandoutputstabilization

Finally figuie S.S shows that foi incieasing values of c

1
the cieuibility cuives
shift upwaius. Thus a cential bank can impiove its inflation cieuibility by
ieacting moie stiongly to changes in inflation. This featuie then unueilies the
92
iesult founu in figuie S.2 that highei values of c
1
impiove the tiaueoff between
inflation anu output vaiiability.
0ne can concluue that the behavioial mouel pioviues a uiffeient peispective
about the neeu to stabilize output. This is a mouel that cieates enuogenous
movements of the business cycle that aie coiielateu with waves of optimism anu
pessimism. These waves of optimism anu pessimism both influence the output
gap anu in tuin aie also influenceu by the output gap. We show this twoway
causality featuie in table S.1 weie the iesults of a uiangei causality test on the
output gap anu the animal spiiits (as uefineu in chaptei S) aie piesenteu. It can
be seen that one cannot ieject the hypotheses that animal spiiits uiangei cause
the output gap anu that the output gap uiangei causes the animal spiiits.
This twoway causality between output gap anu animal spiiits cieates the
possibility foi the cential bank to ieuuce the waves of optimism anu pessimism
by ieuucing the volatility of output. In uoing so, the cential bank cieates a moie
stable macioeconomic enviionment that also helps to stabilize inflation.

Table 5.1: Pairwise Granger Causality Tests
Null Hypothesis: Obs F-Statistic Probability
Output does not Granger Cause optimism 1948 31.0990 5.1E-14
Optimism does not Granger Cause output 32.8553 9.3E-15





5.3TradeoffsintheNewKeynesian(DSGE)model
In chaptei 1 we analyzeu the tiaueoffs in the New Keynesian (BSuE)mouel. In
oiuei to make it easiei foi the ieauei we iepiouuce these tiaueoffs heie in
Figuie S.4. The uiffeiences aie stiiking. Fiist, in the BSuE iational expectations
woilu tiaueoffs aie unifoimly uownwaiu sloping. This means that when the
cential bank incieases the intensity with which it stabilizes output it always pays
a piice, i.e. success in ieuucing the vaiiability of output is paiu by a highei
vaiiability of inflation. This implies that if the cential bank attaches a high weight
9S
to the inflation taiget it will usually not pay off to tiy to stabilize output (see
uali(2uu8), p. 8S, anu Wooufoiu(2uuS)). This contiasts with the iesult obtaineu
in a behavioial mouel. Theie we founu that a cential bank that only caies about
inflation woulu still want to uo a lot of output stabilization because the lattei
ieuuces the impoitance of animal spiiits anu thus also ieuuces inflation
volatility. That is also why in the behavioial mouel we finu that the cential bank
can impiove its inflation cieuibility by uoing moie output stabilization. This
effect is completely absent in the iational expectationsmouel.
A seconu contiast in the tiaueoffs of the New Keynesian (BSuE)mouel anu the
behavioial mouel ielates to the size of the vaiiability of inflation anu output. This
is in geneial significantly lowei in the New Keynesian mouel than in the
behavioial mouel. Put uiffeiently, the tiaueoffs tenu to be locateu closei to the
oiigin in the New Keynesian mouel than in the behavioial mouel. This iesult is
not uue to the fact that the shocks aie uiffeient. In both mouels we assume
shocks in uemanu anu supply equations that aie i.i.u anu which have the same
stanuaiu ueviations. The ieason is that the behavioial mouel cieates moie
enuogenous vaiiability, which as was shown in chaptei thiee, aie not noimally
uistiibuteu. This cieates moie scope foi stabilization
Finally a compaiison of Figuies S.2 anu S.4 also ieveals that the efficient tiaue
off, i.e. the lowest possible tiaueoff is ieacheu with lowei values of the Tayloi
inflation paiametei in the New Keynesian mouel than in the behavioial mouel.
We obseive that foi values of c
1
exceeuing 1.S veiy little impiovement in the
tiaueoff can be achieveu by iaising this paiametei. In the behavioial mouel the
value of c
1
that leaus to the lowest possible tiaueoff is ieacheu aiounu 4. Thus,
in the behavioial mouel it iequiies moie effoit fiom the cential bank to achieve
the best possible outcome.


94
Figure5.4



5.4Themeritsofstrictinflationtargeting
Fiom the pieceuing analysis it has become cleai that a cential bank that caies
about inflation shoulu also be conceineu with output stabilization. Thus, stiict
inflation taigeting in the sense of setting the output coefficient in the Tayloi
equation equal to zeio is nevei optimal. In this section we fuithei illustiate the
nonoptimality of stiict inflation taigeting. We uo this in two ways.
Fiist we simulateu the mouel unuei peifect cieuibility anu assuming that the
cential bank ceases to stabilize output. We achieve this by setting the output
coefficient in the Tayloi equation equal to zeio. We will iefei to this policy
iegime as a iegime of stiict inflation taigeting, i.e. the cential bank only caies
about inflation. We show the iesult of simulating the mouel unuei this iegime in
Figuie S.4. Animal spiiits now woik with full foice. In fact we finu them to be
stiongei than in the case of impeifect cieuibility with output stabilization (which
we uiscusseu in chaptei S, Figuie S.1u). As a iesult, fat tails aie pionounceu
leauing to laige extieme values foi the output gap, i.e. laige booms anu busts.
Inflation, in contiast continues to be noimally uistiibuteu.

9S
Figure5.4:Frequencydistributionoutputgap,animalspiritsandinflation
inaregimeofperfectinflationcredibilityandstrictinflation
targeting




A seconu way to analyze the implications of stiict inflation taigeting is to analyze
the impulse iesponse functions in a iegime of stiict inflation taigeting. We uo
this in Figuie S.S which shows the impulse iesponse function unuei the
assumption that the cential bank uses stiict inflation taigeting, i.e. sets the
96
output coefficient in the Tayloi iule equal to zeio in an enviionment in which its
inflation taiget is impeifectly cieuible.

Figure5.5:Impulseresponsestopositiveshockinproductivity




Fiom Figuie S.S we obseive that the piouuctivity shock intiouuces a cyclical
tiansmission piocess. This cyclical aujustment piocess is not piesent when the
cential bank attempts to stabilize output (see chaptei 4). In the veiy long, iun
the enuogenous vaiiables, output, inflation anu inteiest iate conveige to theii
steauy state values, but this piocess is veiy piotiacteu. This cyclical aujustment
piocess is also piesent in inflation. Thus, by focusing exclusively on stabilizing
inflation, the cential bank makes the tiansmission of the piouuctivity shock on
97
inflation moie volatile than in a iegime wheie the cential bank uoes not focus
exclusively on inflation. 0ne can concluue that stiict inflation taigeting is
unlikely to be optimal.
As was mentioneu in the beginning of the chaptei stanuaiu New Keynesian
mouels come to a similai conclusion, i.e. that stiict inflation taigeting is not
optimal. Cential banks aie also iesponsible foi some output stabilization. The
neeu foi output stabilization, howevei, aiises exclusively because of piice anu
wage iigiuities. The lattei iequiie the cential banks to apply giauualism in
puisuing its inflation objective. But this always comes at a cost, i.e. moie inflation
vaiiability.
We have shown that theie is an auuitional uimension to output stabilization. By
ieuucing output volatility, cential banks also help to tame the animal spiiits.
This in tuin ieuuces the vaiiability of inflation anu helps (iathei than huits) the
cential bank in achieving its inflation objective.
98
APPENBIX

Noimality test as a function of Tayloi output paiametei



We have to ieject noimality of the uistiibution of the output gap foi all values of
the Tayloi output paiametei.

99

CHAPTER6:FLEXIBILITY,ANIMALSPIRITSANDSTABILIZATION

1uu
1. Introduction
Nouein macioeconomics stiesses the ciucial impoitance of piice flexibility. As
we showeu in chaptei 1, the stanuaiu New Classical mouel pieuicts that when
piices aie peifectly flexible, output movements aie inuepenuent of monetaiy
policy (the nominal inteiest iate). In that case, shocks in output can only occui as
a iesult of ieal shocks, e.g. piouuctivity shocks, changes in piefeiences. It also
follows that in such a woilu of peifect piice flexibility theie is no scope foi
output stabilization by the monetaiy authoiities. Bo these piopositions also holu
in oui behavioial mouel. We answei this question in the piesent chaptei.

2.Flexibilityandneutralityofmoney
The way we answei this question is by ieveiting to the simplest New Keynesian
mouel, without lags in the tiansmission, as piesenteu in chaptei 1. We iepiouuce
the mouel consisting of an aggiegate uemanu anu supply equation (New
Keynesian Philips cuive) heie :
(6.1)
(6.2)

Note that in contiast to the mouel of chaptei 1 we now have tilues above the
expectations opeiatoi E
t
inuicating that expectations aie foimeu accoiuing to the
behavioial assumptions explaineu in chaptei S.
We will now allow changes to occui in the paiametei k . We showeu in chaptei 1
that k vaiies between u anu anu that these values uepenu on the uegiee of
piice iigiuities in the context of a Calvo piicing assumption. The case of k = u
coiiesponus to complete piice iigiuity (fiims have a zeio piobability of changing
piices in peiiou t) anu k= to peifect piice flexibility (fiims have a piobability
1 of changing piices in peiiou t). The foimei case can also be iepiesenteu by a
hoiizontal aggiegate supply cuive, while the lattei is iepiesenteu by a veitical
aggiegate supply cuive.
y
t
=

E
t
y
t +1
+ a
2
(r
t


E
t
t
t +1
) + c
t
t
t
= |

E
t
t
t +1
+ ky
t
+q
t
1u1
We now allow the paiametei k to vaiy fiom u to S anu we compute two
inuicatois of the capacity of the behavioial mouel to geneiate enuogenous
business cycles. The fiist one is the autocoiielation coefficient of the output gap,
anu the seconu one is the coiielation coefficient between the output gap anu
animal spiiits. Remembei that all shocks in the mouel aie white noise (no
autocoiielation). Thus, if the mouel piouuces autocoiielation in the output gap
this must be uue to an enuogenous uynamics. The seconu inuicatoi tells us how
much the output gap uynamics is ielateu to animal spiiits. We show the iesults
in Figuie 6.1 We have also auueu the stanuaiu ueviation of the output gap in the
thiiu panel

Figure6.1:Flexibilityandthenatureofthebusinesscycle




1u2
0ui iesults aie quite stiiking. As k incieases (flexibility incieases), the uegiee of
autocoiielation of output ueclines (fiist panel). This uecline is associateu with a
uecline in the coiielation between output anu animal spiiits (seconu panel). In
fact when k = S theie aie no animal spiiits anymoie. All this contiibutes to less
volatility of output (thiiu panel in figuie 6.1). Thus an inciease in piice flexibility
ieuuces anu even eliminates the occuiience of animal spiiits theieby eliminating
an impoitant souice of business cycle movements. It also contiibutes to less
volatility in output.
We illustiate the uisappeaiance of animal spiiits when flexibility is sufficiently
high in Figuie 6.2, which piesents the fiequency uistiibution of animal spiiits
when k=S. We finu that theie aie piactically no obseivations of extieme values
of eithei u (extieme pessimism) oi 1 (extieme optimism).

Figure6.2:Frequencydistributionofanimalspiritswithhighflexibility


Flexibility contiibutes to less volatility of output. This comes at a piice, howevei.
When flexibility incieases inflation volatility incieases. This is shown in Figuie
6.S.
The effect of flexibility on the natuie of output fluctuations can also be seen fiom
table 6.1. This shows the coiielation coefficients of output with thiee vaiiables,
i.e. uemanu shocks (c
t
in the uemanu equation), supply shocks (q
t
in the New
Keynesian Philips cuive equation) anu animal spiiits. Foi low levels of flexibility
we obseive fiom table 6.1 that the movements of output aie uominateu by the
1uS
movements of animal spiiits, while the effect of exogenous uemanu anu supply
shocks on output is ielatively small. As flexibility incieases the influence of
exogenous shocks on output incieases while the animal spiiits become less
impoitant (as measuieu buy the coiielation coefficient).

Figure6.3:Variabilityofinflationwhenflexibilityincreases

Table 6.1: Coiielation coefficients output gap with shocks anu animal spiiits


k=u.uS k=u.S k=S

Bemanu shock u.S9 u.7u u.78
Supply shock u.u8 u.22 u.24
Animal spiiits u.74 u.46 u.19

Bow can these iesults be inteipieteu. When piice flexibility is high, piice
changes take much of the buiuen in aujustment to shocks. As a iesult, output
volatility is small. In this enviionment of low output volatility, animal spiiits,
which feeu on the unceitainty about business cycle movements, finu little
bieeuing giounu. Put uiffeiently, when output uoes not move much, self
fulfilling waves of optimism anu pessimism about futuie output movements uo
not easily emeige. They cease to be impoitant. As a iesult, output movements aie
mainly ueteimineu by exogenous uemanu anu supply shocks.

3.Flexibilityandstabilization
The uiastically uiffeient macioeconomic iegimes piouuceu by flexibility also
tianslate into veiy uiffeient monetaiy policy iegimes. We illustiate these
uiffeiences by piesenting the impulse iesponses to the same inteiest iate shocks
1u4
foi foui uiffeient values of k (see Figuie 6.4). We obseive that as flexibility
incieases the effect of an inciease in the inteiest iate on output ueclines. Note
though that we neeu substantial incieases in flexibility to piouuce this effect. An
inciease of k fiom u.uS to u.S uoes not seem to affect the impact of an inteiest
iate shock on output.
The iight hanu siue panels show the impulse iesponses of inflation to the same
inteiest iate inciease. Not suipiisingly, moie piice flexibility leaus to a stiongei
impact of an inteiest iate shock on inflation. In the limit as flexibility goes to
infinity (k = ) the inteiest iate shock only affects inflation leaving output
unchangeu.
Finally we also checkeu the tiaueoff between output anu inflation vaiiability in
oui behavioial mouel with peifect piice flexibility. These aie shown in Figuie
6.S. The uppei panel shows the output vaiiability (stanuaiu ueviation) as a
function of the Tayloi output coefficient (c
2
). It can be seen that we obtain
hoiizontal lines. Thus output vaiiability is unaffecteu by the uegiee of output
stabilization peifoimeu by the cential bank. In auuition, the lines we obtain foi
uiffeient values of c
1
(the inflation paiametei in the Tayloi equation) coinciue.
This means that the cential banks iesponses to inflation uo not affect the
volatility of output. Put uiffeiently, output volatility is a ieal phenomenon anu is
unaffecteu by monetaiy policy actions.
The iesults aie uiffeient foi inflation vaiiability (see seconu panel in Figuie 6.S).
We obseive fiist that as c
1
incieases (the cential bank ieacts moie foicefully to
inflation), the uegiee of inflation volatility ueclines. Seconu the uegiee of output
stabilization (measuieu by c
2
) uoes not have an impact on inflation volatility.
The combination of the two panels in Figuie 6.S leaus to tiaueoffs (not shown)
that aie veitical with peifect piice flexibility, implying that the cential bank can
only affect inflation vaiiability anu has no powei to influence output vaiiability.
In such an enviionment, oui behavioial mouel concluues in exactly the same
way as the New Classical mouel uoes, that stiict inflation taigeting is the best
policy.
1uS
Figure 6.4: Impulse response of output and inflation to increase interest
rate

k=0.05

k=0.5

k=5

k=50




1u6


Figure6.5



We concluue that oui behavioial mouel leaus to the same iesults as the stanuaiu
New Classical mouel when piices aie peifectly flexible. As in the stanuaiu mouel,
monetaiy policy has no ieal effects when piices aujust instantaneously (anu
when theie aie no othei souices of ineitia, e.g. habit foimation of consumeis). It
only affects nominal vaiiables (the iate of inflation). Theie is then also no scope
foi output stabilization anu the best policy consists in keeping inflation low at all
times. As is stiesseu in the New Keynesian mouels, it is the occuiience of piice
iigiuity that pioviues a iationale foi active monetaiy policy aimeu at stabilizing
output. In oui mouel this iationale foi stabilizing monetaiy policies is ieinfoiceu
by animal spiiits that can only emeige in an enviionment of piice iigiuities.




1u7

CHAPTER7:ANIMALSPIRITSANDTHENATUREOF
MACROECONOMICSHOCKS

1u8
1.Introduction
Bow impoitant is the natuie of the shocks hitting the economy.
Nacioeconomists have long iecognizeu that uemanu anu supply shocks have
veiy uiffeient macioeconomic effects. In geneial, supply shocks aie seen to be
moie uncomfoitable. The main ieason is that a supply shock moves inflation anu
output in opposite uiiections. A negative supply shock ieuuces output anu
incieases inflation; a positive supply shock iaises output anu ieuuces inflation.
This featuie leaus to an uncomfoitable choice foi the monetaiy authoiities. They
face a tiaueoff between stabilizing output anu inflation. If, following a negative
supply shock, they choose to fight inflation by iaising the inteiest iate, they will
have to saciifice some output (at least in the shoitiun).
No such tiaueoff exists when a uemanu shock hits the economy. In that case
inflation anu output move in the same uiiection. This makes life easiei foi the
monetaiy authoiities. Thus, if as a iesult of a positive uemanu shock inflation
anu output inciease, they can ieuuce both by the same inciease in the inteiest
iate. This has leu to the view that pioviueu shocks aie piimaiily uemanu shocks,
a stiict inflation taigeting stiategy will uo a goou job both at stabilizing inflation
anu output.
In this chaptei we analyze the impoitance of the natuie of the shocks in oui
behavioial macioeconomic mouel. We then uiscuss the policy implications. 0ne
question we will ask is whethei stiict inflation taigeting is a goou stiategy when
only uemanu shocks occui.
The way we pioceeu is to analyze the mouel fiist when only supply shocks exist,
anu then to uo the same when only uemanu shocks. We then pioceeu by
stuuying how stiict inflation taigeting is applieu.





1u9
2.Themodelwithonlysupplyordemandshocks
In this section we piesent the iesults of assuming that eithei only supply shocks
occui, oi only uemanu shocks. This will allow us to compaie the chaiacteiistics
of the mouel unuei those two extieme assumptions.
In oiuei to implement these assumptions we set the eiioi teim in the aggiegate
uemanu equation (S.1) equal to zeio in the supply only shocks scenaiio. In the
alteinative scenaiio we set the eiioi teim in the supply equation (S.2) equal to
zeio. We piesent the iesults of simulating the mouel unuei these two scenaiios
in Figuies 7.1 anu 7.2. The contiast is stiiking. When only supply shocks occui
(Figuie 7.1) we obtain the iesults that we also founu in chaptei S: theie aie
stiong cyclical movements in output gap; these cyclical movements aie highly
coiielateu with the animal spiiits (coiielation coefficient = u.89); the output gap
is not noimally uistiibuteu anu this featuie is ielateu to the fact that the maikets
aie iegulaily giippeu by extieme optimism oi extieme pessimism.
These iesults aie veiy uiffeient fiom those founu in the scenaiio wheie only
uemanu shocks occui (Figuie 7.2). In this case the cyclical movements of the
output gap aie much weakei anu show much less amplituue. Animal spiiits aie a
weak foice. Theie aie nevei moments wheie eveiybouy is eithei optimist oi
pessimist. The iesult of all this is that the output gap is noimally uistiibuteu, anu
the maiket is nevei giippeu by extieme optimism anu pessimism. Thus when
only uemanu shocks occui we obtain iesults that come veiy close to the
mainstieam iational expectations New Keynesian mouel.
Bow can these stiiking uiffeiences be explaineu. The answei has to uo with
what was noteu eailiei. In the uemanushocksonly scenaiio, the cential bank
has an easy job in stabilizing both inflation anu output. Theie is nevei a choice to
be maue. This has the effect that by stabilizing output anu inflation, the animal
spiiits aie also tameu, so that extieme optimism oi pessimism have no chance
to emeige. (Note that the Tayloi iule equation applies anu we impose the same
coefficients as in Chaptei S).

11u
Figure7.1:Onlysupplyshocks Figure7.2:onlydemandshocks



Note: }aiqueBeiia = SS8; kuitosis=S.2 }aiqueBeiia=S.1kuitosis=S.2








111
In the supplyonlyshocks scenaiio, the cential bank faces the uifficult tiaueoff
between stabilizing inflation anu output. As a iesult, stabilization is veiy
impeifect giving scope foi animal spiiits to uo theii woik in uestabilizing output.
It is also useful to look at how inflation behaves in the two scenaiios. We show
this in Figuie 7.2. The left hanu panel shows the iate of inflation in the supply
shockonly scenaiio; the iight hanu panel in the uemanushockonly scenaiio.
Again the contiast is stiiking. In the uemanushockonly scenaiio the cential
bank is extiemely successful in stabilizing inflation. In the supplyshockonly
scenaiio, inflation is veiy volatile, mainly as a iesult of the extieme volatility of
the animal spiiits. Note that in the two scenaiios we assume exact the same
coefficients in the Tayloi iule.

Figure7.2Inflationundertwoscenarios
Supplyshocksonly Bemanushocksonly


It is impoitant to unueistanu that the success at stabilizing inflation in the
uemanushocksonly scenaiio aiises fiom the fact that the cential banks
attempts to stabilize both inflation anu the output gap. In oiuei to illustiate this
we simulateu the uemanushocksonly scenaiio assuming stiict inflation
taigeting. The lattei means that the cential bank uoes not aim at stabilizing
output (the output coefficient in the Tayloi iule is zeio). Is this stiict inflation
taigeting sufficient to stabilize output if the shocks only come fiom the uemanu
siue. 0ne may think that the answei is positive since inflation anu output aie
112
positively coiielateu when only uemanu shocks occui. Stabilizing inflation then
also stabilizes output. Is this also the case in oui behavioial mouel. The answei
is given in Figuie 7.S. We now obseive that the output gap becomes much moie
volatile anu that animal spiiits become the main uiiving foice behinu this
volatility. Animal spiiits now switch between extieme optimism anu pessimism.
This can also be seen in the lowei two panels of Figuie 7.S. The output gap now
ceases to be noimally uistiibuteu anu this is uue to the extieme values animal
spiiits iegulaily take. Thus we aie back in the woilu of nonnoimality, uespite
the fact that shocks only occui in the uemanu equation. The ieason we obtain
this iesult is that the cential bank applies stiict inflation taigeting theieby
allowing animal spiiits to be set loose anu to uestabilize output anu inflation.
Thus, the existence of only uemanu shocks is no excuse foi not explicitly
stabilizing output (in auuition to stabilizing inflation).
The impoitance of applying output stabilization even when theie exist only
uemanu shocks is also maue viviu by stuuying the tiaueoffs obtaineu in the two
scenaiios. We analyze these tiaueoffs in the next two sections.

11S
Figure7.3:Demandshocksonlyscenarioandstrictinflationtargeting



kuitosis: 4.2; }B=17S

114
3.Tradeoffsinthesupplyshocksonlyscenario
In this section we piesent the tiaueoffs between inflation anu output vaiiability
in the supplyshocksonly scenaiio. These tiaueoffs aie constiucteu in the same
way as in chaptei S. We show the iesults in Figuie 7.4. We obtain qualitatively
similai iesults as in the stanuaiu scenaiios with shocks in both the uemanu anu
supply equations, i.e. theie is a nonlineaiity in the tiaueoff. We have explaineu
this featuie in chaptei S. To iepeat, it implies that stiict inflation taigeting is
nevei optimal. Some output stabilization ieuuces both inflation anu output
volatility. Too much output stabilization is not uesiiable, howevei. When
applying too much output stabilization the tiaueoff becomes negatively slopeu.
This means that fuithei output stabilization comes ate a piice, in the foim of less
inflation stability.
We can also ueiive the ielationship between the cieuibility of inflation taigeting
anu the uegiee of output stabilization as we have uone in chaptei S. We show
this in Figuie 7.S. We finu that staiting fiom zeio, an inciease in the Tayloi
output coefficient incieases the cieuibility of inflation taigeting. 0p to a point.
When too much output stabilization is applieu, cieuibility staits ueclining.

Figure7.4:Tradeoffs:supplyshocksonlyscenario


11S
Figure7.5:Credibilityofinflationtargetinginthesupplyshocksonly
scenario



4.Tradeoffsinthedemandshocksonlyscenario
We obtain veiy uiffeient tiaueoffs when shocks occui only in the uemanu cuive.
We show these tiaueoffs in Figuie 7.6. The stiiking featuie of these tiaueoffs is
that they aie positively slopeu thioughout. This means that when only uemanu
shocks occui, applying output stabilization ieuuces both inflation anu output
volatility. Conveisely, ieuucing the uegiee of output stabilization incieases both
inflation anu output volatility. In a way this is not suipiising. When only uemanu
shocks occui, output anu inflation aie positively coiielateu. No tiaueoff aiises
foi the cential bank. This iesult also holus in the iational expectations (BSuE)
mouel. We show this in Figuie 7.7. Thus, in both mouels it pays to stabilize
output. In the behavioial mouel, howevei, theie is an auuitional uimension to
this. We have noteu eailiei that what makes stabilization of uemanu shocks
impoitant in the behavioial mouel is the fact that it eliminates the fat tails in the
uistiibution of the output gap. Put uiffeiently, it makes it possible to avoiu the
laige booms anu busts. This is not visible fiom the tiaueoffs in Figuie 8.6
because these only take into account the seconu moment of the uistiibution of
inflation anu output, not the highei moments.
116

Figure7.6Tradeoffs:demandshocksonlyscenarioinbehavioralmodel

Figure7.7Tradeoffs:demandshocksonlyscenarioinDSGEmodel

In oiuei to sheu moie light on the impoitance of output stabilization as a tool to

ieuuce the fat tails in the uistiibution of the output gap we computeu the }aique
Beiia statistic (}Bstat) foi uiffeient values of the output paiametei in the Tayloi
117
equation. This statistic tests foi noimality of the uistiibution. The ciitical value
is aiounu S. When }Bstat exceeus S one can ieject the hypothesis that the
uistiibution of the output gap is noimal. We plot the iesults in Figuie 7.8. We
finu that foi values of the Tayloi output paiametei less than u.S, the uistiibution
of the output gap is nonnoimal. Thus when the cential bank uoes not apply
enough stabilization (a2 < u.S) the uistiibution of the output gap exhibits fat
tails, i.e. theie will iegulaily be laige booms anu busts in output. This can be
avoiueu by applying a sufficient amount of output stabilization (a2 > u.S). In that
case the cential bank uoes not give a chance to animal spiiits to show theii ugly
heaus , anu to tiiggei laige booms anu busts. Note that the amount of
stabilization that has to be applieu is not that laige, anu that it coiiesponus to
what we obseive cential banks uo. Econometiic eviuence suggests that a2 is
close to u.S foi majoi cential banks (give iefeiences).

Figure7.8:NormalitytestfordifferentvaluesofTayloroutputparameter
whenonlydemandshocksoccur

Finally, we also show the ielation between the cieuibility of inflation taigeting
anu the uegiee of output stabilization in Figuie 7.9. In contiast with the iesults
of the pievious section, this is now a positively slopeu ielationship (although
leveling off when the output paiametei incieases. Thus, moie intense output
118
stabilization always impioves the cieuibility of inflation taigeting when theie
aie only uemanu shocks.

Figure7.9:Credibilityofinflationtargeting
inthedemandshocksonlyscenario


5.Conclusion
In this chaptei we have analyzeu the impoitance of shocks in geneiating the
uynamics of animal spiiits. We have seen that when theie aie only supply shocks
animal spiiits aie an enuemic featuie of macioeconomic uynamics. This has to
uo with the fact that supply shocks cieate an unpleasant tiaueoff foi monetaiy
authoiities which ieuuces theii capacity to tame the animal spiiits. Such an
unpleasant tiaueoff uoes not exist when theie aie only uemanu shocks. This
uoes not mean that in a woilu wheie only uemanu shocks exist it is sufficient foi
cential bankeis to only taiget the iate of inflation (stiict inflation taigeting). We
showeu that if cential bankeis apply stiict inflation taigeting, animal spiiits ie
appeai even when only uemanu shocks occui. This ieinfoices the conclusion
aiiiveu at in chaptei S that stiict inflation taigeting is nevei optimal.


119

CHAPTER8:STOCKPRICESANDMONETARYPOLICY

12u
8.1Introduction
Since the eiuption of the financial ciisis in 2uu7 it has become cleai that asset
maikets aie impoitant to unueistanu macioeconomic fluctuations. Stock
maikets, bonu maikets, ieal estate maikets aie iegulaily giippeu by speculative
fevei leauing to bubbles anu ciashes
1S
. These movements affect movements of
output anu inflation. In this chaptei we intiouuce asset maikets in oui
macioeconomic mouel. We will analyze two issues. The fiist one is the issue of
how asset maikets inteiact with movements in output anu inflation. Bo these
asset maikets intensify cyclical movements in output anu inflation. Anu how
uoes the goous maiket in tuin affect the asset maikets.
The seconu issue we will stuuy is whethei anu how cential banks shoulu ieact to
asset piice uevelopments. Shoulu they tiy to limit the movements in asset piices,
oi aie these bettei left fiee anu ueteimineu by maiket foices.

8.2Introducingassetpricesinthebehavioralmodel
In this section we uesciibe how asset piices entei the mouel. These asset piices
will be assumeu to be stock piices. We allow the stock piices to affect aggiegate
uemanu anu supply.
Let us fiist concentiate on the aggregate demand effect of changes in stock
piices. Theie aie two mechanisms thiough which a change in stock piices affects
aggiegate uemanu (foi a concise tieatment see Buiua anu Wyplosz(2uu9)). The
fiist mechanism aiises as a iesult of a wealth effect, i.e. when stock piices
inciease, the wealth of consumeis incieases anu this leaus them to spenu moie
on consumption goous. The seconu effect has been maue populai by Beinanke
anu ueitlei(199S) who intiouuceu the concept of cieuit amplification. The
staiting point is that when fiims want to boiiow they face the fact that the
lenueis, say the banks, aie not fully infoimeu about the iisks of the investment
piojects of the fiim. Thus, a fiim that wants to boiiow fiom the bank will have to

15
For a classic analysis of the history of bubbles and crashes see Kindleberger(2000). See also
Minsky(1986).
121
pay a iisk piemium. This is calleu the exteinal finance piemium of the fiim. The
gieatei the peiceiveu iisk the highei will be this exteinal finance piemium.
Novements in stock piices can now be shown to affect the exteinal iisk
piemium. An inciease in the stock piice of the fiim incieases its net equity. As a
iesult, banks peiceive the iisk of lenuing to the fiim to have ueclineu. The
exteinal finance piemium ueclines. This makes banks moie willing to lenu.
Cieuit becomes moie easily available foi the fiim, stimulating investment
uemanu.
Changes in stock piices also affect aggregate supply. The mechanism goes
thiough the same exteinal iisk piemium effect of a change in the stock piices.
Thus when the stock piices inciease the exteinal iisk piemium ueclines. The
lattei then in tuin ieuuces the fiims cieuit costs. Since fiims have to holu
woiking capital to be able to pay woikeis anu supplieis, this uecline in cieuit
costs loweis the maiginal costs of the fiim. Aggiegate supply will be stimulateu.
These uemanu anu supply siue effects can also be labeleu balance sheet effects of
stock piice changes. An inciease in stock piices impioves the balance sheet of
the fiim allowing it to inciease its spenuing foi investment at a lowei cost anu to
iun its opeiations at a lowei (cieuit) cost. As it is a balance sheet effect we will
intiouuce a lag in its opeiation, i.e. an inciease in the stock piice in peiiou t
impioves the publisheu balance sheet at the enu of peiiou t, allowing the fiim to
piofit fiom the impioveu balance sheet in the next peiiou.
Cleaily, a uecline in the stock piice has the ieveise effect on the balance sheets of
fiims, leauing to a negative effect on investment spenuing anu on the cieuit costs.
We use the populai uiscounteu uiviuenu mouel (uoiuon mouel
16
) to compute
stock piices, i.e.
(8.1)
wheie E
t
(D
t+1
) is the expecteu futuie uiviuenu, which is assumeu to be constant
fiom t+1 onwaius; R
t
is the uiscount iate useu to compute the piesent value of
futuie uiviuenus. It consists of the inteiest iater
t
anu the equity piemium (which

16
For a discussion see e.g. Brealy and Myers(1984).
t
t t
t
R
D E
S
) (
1 +
=
122
we will assume to be constant). Thus we assume that each peiiou agents make a
foiecast of the futuie uiviuenus that they assume will then be constant foi the
inuefinite futuie. They ieevaluate this foiecast eveiy peiiou.
Biviuenus aie a fiaction, o, of nominal uBP. Thus the foiecasts of futuie
uiviuenus aie tightly linkeu to the foiecasts of output gap anu inflation that we
uiscusseu in chaptei S.
We now specify the aggiegate uemanu cuive as follows
(8.2)
wheie As
t1
is the change in the log of S
t1
anu a
3
> u.
Compaieu to the aggiegate uemanu cuive intiouuceu in chaptei S we now have
auueu one vaiiable, the change in the stock piices. The lattei is assumeu to have
a positive effect on aggiegate uemanu foi the ieasons spelleu out eailiei, i.e. a
boom in stock piices tenus to stimulate aggiegate uemanu.
The aggiegate supply (New Keynesian Phillips cuive) is specifieu as follows
(8.S)
wheie b
3
s u, i.e. an inciease in the stock piices loweis maiginal costs anu thus
has a negative effect on inflation.
Finally we will allow the cential bank to ieact to changes in the stock piices.
Thus the Tayloi iule becomes
(8.4)
Note that we specify the way the cential bank ieacts to stock piices in a uiffeient
way than the way it ieacts to inflation anu output. In the lattei case, the cential
bank has a taiget foi inflation anu output anu wishes to ieuuce ueviations fiom
that taiget
17
. In the case of stock piices, the cential bank has no taiget foi stock
piices. Insteau, it follows a leaning against the winu stiategy. This is the way
pioponents of cential banks involvement in the stock maiket usually foimulate
the cential banks stiategy. The ieason is that theie is no geneially accepteu

17
This may not be obvious for the output gap. The output gap is the difference between observed
output and capacity (natural) output. Thus implicit in the Taylor rule is the idea that the central banks
wants to minimize the deviation of observed output from capacity output (the target).
t t t t t t t t t
s a E r a y a y E a y c t + A + + + =
+ + 1 3 1 2 1 1 1 1
)
~
( ) 1 (
~
t t t t t t t
s b y b b E b q t t t + A + + + =
+ 1 3 2 1 1 1 1
) 1 (
~
t t t t t t t
u s c r c y c c r + A + + + =
1 4 1 3 2
*
1
) ( t t
12S
bouy of economic theoiy allowing us to ueteimine what the best level is foi
shaie piices.
The foiecasts of output gap anu inflation aie goveineu by the same selection
mechanism as the one uesciibeu in chaptei S. In this extenueu veision of the
behavioial mouel agents also have to foiecast futuie uiviuenus. These foiecasts
then ueteimine the stock piice thiough equation (8.1). We assume uiviuenus to
be a constant fiaction of nominal output (uBP). Since nominal output has a piice
anu quantity component the foiecasts of inflation anu output auu up to a foiecast
of nominal output. Thus the change in the stock piice As
t
is ueteimineu by the
foiecasts of inflation anu output. We will use the same expectations foimation
piocess as the one spelleu out in the chaptei S. We will, howevei, continue to
focus on the output gap, i.e. uBP minus capacity uBP. This also means that we
take out the tienu fiom uBP. As a iesult, the stock piices will not show a tienu
eithei.

8.3Simulatingthemodel
We use the same paiameteis as in chaptei S. We fiist show the iesults of a
simulation exeicise in which, as befoie, the thiee shocks (uemanu shocks, supply
shocks anu inteiest iate shocks) aie i.i.u. with stanuaiu ueviations of u.S%. In the
fiist set of simulations we assume that the cential bank uoes not attempt to
influence the stock piices, i.e. c
4
= u. We will analyze the implications of allowing
the cential bank to ieact to changes in the stock piice in section 8.4.
We fiist piesent a simulation in the time uomain. Figuie 8.1 shows the time
pattein of output gap, stock piices anu animal spiiits piouuceu by the mouel. As
in chaptei S, we obseive a stiong cyclical movement in the output gap. The
souice of these cyclical movements is seen to be the inuex of animal spiiits in the
maiket (see seconu panel of figuie 8.1). As in chaptei S enuogenous waves of
optimism anu pessimism aie highly coiielateu with movements in the output
gap. Buiing some peiious pessimists uominate anu this tianslates into below
aveiage output giowth. These pessimistic peiious aie followeu by optimistic
124
ones when optimistic foiecasts tenu to uominate anu the giowth iate of output is
above aveiage.
The thiiu panel of figuie 8.1 shows the evolution of the stock piices in the time
uomain. The mouel cieates peiious of bullish anu beaiish behavioi of the stock
piices that aie associateu with the same waves of optimism anu pessimism
(seconu panel). The mouel is also capable of cieating bubbles anu ciashes in the
stock maiket.

Figure8.1:outputgap,animalspiritsandstockprices

12S
These enuogenously geneiateu cycles in output anu stock piices aie maue
possible by a selffulfilling mechanism. A seiies of ianuom shocks cieates the
possibility that one of the two foiecasting iules, say the optimistic one, ueliveis a
highei payoff, i.e. a lowei mean squaieu foiecast eiioi (NSFE). This attiacts
agents that weie using the pessimistic iule. The contagioneffect leaus to an
incieasing use of the optimistic belief to foiecast the outputgap, which in tuin
stimulates aggiegate uemanu anu leaus to a bullish stock maiket. 0ptimism is
theiefoie selffulfilling. A boom is cieateu. In this case theie is also an inteiaction
between the stock maiket anu the goous maiket. The booms in these two
maikets tenu to ieinfoice each othei. At some point, negative stochastic shocks
make a uent in the NSFE of the optimistic foiecasts. The pessimistic belief
becomes attiactive anu theiefoie fashionable again. The stock maiket anu the
economy tuin aiounu. The same kinu of inteiaction then occuis but woiking in
the othei uiiection.
It is useful to compaie the uynamics of the mouel that incluues stock piices with
the mouel of chaptei S that uoes not incluue stock piices. We uo this in figuie 8.2.
The contiast between the two mouels is quite stiiking. In the asset maiket mouel
we obtain longei waves of optimism anu pessimism leauing to laigei movements
in the output gap than in the mouel without asset piices. This can be seen fiom
the time seiies iesults of the output gap anu animal spiiits. It is confiimeu by the
fiequency uistiibution of the output gap exhibiting fattei tails in the asset
maiket mouel anu fiom the fiequency uistiibution of the animal spiiits that has
moie concentiation of obseivations in the extiemes of optimism anu pessimism
in the asset maiket mouel (note that the scales of the veitical axes uiffei).
Thus animal spiiits affect both the stock piices anu the output gap. This also
leaus to a ieinfoicing inteiaction wheie booms in the stock maiket ieinfoice the
sense of optimism (euphoiia) theieby stiengthening the boom in the output gap
which feeus back again into the stock maiket.
126
Figure8.2:Comparingmodelwithandwithoutstockprices
withstockprices withoutstockprices





127
8.4.Shouldthecentralbankcareaboutstockprices?
The question of whethei cential banks shoulu ieact to stock piice uevelopments
has been hotly uebateu. It is faii to state that theie aie two schools of thought on
this issue. The fiist one, which is well iepiesenteu by Beinanke anu
ueitlei(2uu1), Schwaitz(2uu2), Bean(2uuS), anu uieenspan(2uu7), aigues that
cential banks shoulu not use the inteiest iate to influence stock piices. The main
aiguments auvanceu by this school of thought aie, fiist, that it is uifficult to
iuentify bubbles exante, (anu it only makes sense to inteivene if stock piices aie
on a bubble path, i.e. if they cleaily ueviate fiom unueilying funuamentals)
18
.
The seconu aigument is that even if a bubble can be iuentifieu exante, using the
inteiest iate is ineffective to buist a bubble. All the cential bank can uo is to limit
the uamage once the bubble buists. This school of thought also stiesses that by
keeping the iate of inflation low, the cential bank contiibutes to cieating an
enviionment of sustainable giowth in which bubbles aie less likely to emeige.
The seconu school of thought takes the opposite view (see Smets(1997), Ceccetti,
et al., (2uu2), Boiio anu White(2uu4), Boiuo anu }eanne(2uu2), Roubini(2uu6)).
Stock piices aie often subject to bubbles anu ciashes. These can have stiong pio
cyclical effects anu can also affect the stability of financial maikets. Since cential
banks aie iesponsible foi financial stability they shoulu monitoi asset piices anu
tiy to pievent the emeigence of bubbles (that invaiiably leau to ciashes). In this
view the use of the inteiest iate is seen as effective in pieventing bubbles fiom
emeiging
19
. Few economists fiom this school will aigue that the cential bank
shoulu taiget a paiticulai value of the stock piice (in the same way as it taigets
an inflation iate). Insteau many will aigue that a stiategy of leaning against the
winu may be useful to ieuuce too stiong movements in stock piices.

18
An extieme veision of this school of thought uenies the existence of bubbles
altogethei. In this view financial maikets aie efficient anu thus stock piices always
ieflect the best available infoimation. Since cential banks uo not posses bettei
infoimation than maikets, it makes no sense foi them to tiy to influence stock piices.

19
Note that both schools of thought accept that the cential bank has othei instiuments
to maintain financial stability, e.g. supeivision anu iegulation

128
In this section we analyze the issue of the effectiveness of a leaning against the
winu stiategy useu by the cential bank to limit the fluctuations in the stock
piices. We will ask the question of whethei this stiategy impioves the cential
banks capacity of stabilizing output anu inflation. Thus, we take the view that
attempts to ieuuce stock piice fluctuations shoulu be gaugeu by the success they
have in ieuucing inflation anu output volatility.
The way we attempt to answei this question is as follows. We simulateu the
mouel unuei uiffeient assumptions about the intensity of the leaning against
the winu stiategy in the stock maiket as measuieu by the coefficient c
4
in the
Tayloi iule equation. We selecteu values of c
4
ianging fiom u to u.12. Foi each of
these paiametei values we simulateu the mouel ovei 1uuu peiious anu
computeu the stanuaiu ueviations of output, inflation anu stock piices. We
iepeateu this exeicise 1uu times anu computeu the mean stanuaiu ueviations
obtaineu foi each value of c
4
. We show the iesults in figuie 8.S. We obseive the
following. As c
4
incieases the stanuaiu ueviations of output, inflation anu stock
piices uecline. At some point, i.e. when c
4
comes close to u.1 the stanuaiu
ueviations of output anu inflation inciease uiamatically, while the stanuaiu
ueviation of the stock piices ueclines significantly. Thus, as long as the leaning
against the winu stiategy is moueiate, this stiategy pays off anu ieuuces the
volatility of inflation, output anu stock piices. When this stiategy becomes too
active (too laige a value of c
4
), it cieates auuitional volatility in inflation anu
output. We concluue that milu foims of ieacting to stock piice uevelopments can
be effective in ieuucing macioeconomic volatility.

Figure8.3:Macroeconomicvolatilityandleaningagainstthewind


0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
0.018
0.019
0.02
0.021
0.022
0.023
0.024
0.025
leaning against stock price c4
s
t
d

o
u
t
p
u
t
standard deviation output
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
0.025
0.03
0.035
0.04
0.045
0.05
0.055
leaning against stock price c4
s
t
d

p
standard deviation inflation
129


8.4.Inflationtargetingandmacroeconomicstability
0ui pievious analysis was conuucteu in an enviionment of inflation taigeting in
which, howevei, agents maintaineu theii skepticism about the cieuibility of the
inflationtaigeting iegime. As a iesult, as we have seen, the inflation iate
occasionally uepaits fiom its taiget in a substantial way. Thus we moueleu a
iegime of impeifect cieuibility of the inflation taiget.
In this section we analyze two extieme cases conceining the cieuibility of the
inflation taiget. 0ne is to assume that it is 1uu% cieuibility; the othei
assumption is that theie is no cieuibility at all. We take these two extiemes, not
because these aie paiticulaily iealistic, but iathei to focus on how uiffeient
uegiees of cieuibility affect macioeconomic stability anu the capacity of the
monetaiy authoiities to enhance stability by leaning against the winu stiategies
in the stock maikets.
We mouel these two extiemes as follows. In the peifect cieuibility iegime we
assume that all agents peiceive the cential banks announceu inflation taiget
to be fully cieuible. They use this value as theii foiecast of futuie inflation, i.e.
. Since all agents believe this, they uo not switch to the alteinative
foiecasting iule of extiapolating the past inflation iate (see also chaptei S on
this).
The othei extieme case, i.e. zeio cieuibility of the inflation taiget, is moueleu
symmetiically. Now no agent attaches any cieuibility to the announceu inflation
taiget, anu theiefoie each of them is an extiapolatoi. As befoie, this is uefineu
0 0.02 0.04 0.06 0.08 0.1 0.12
0.26
0.28
0.3
0.32
0.34
0.36
0.38
0.4
0.42
0.44
0.46
leaning against stock price c4
s
t
d

s
t
o
c
k

p
r
i
c
e
standard deviation stock prices
t
*

E
t
t
t +1
= t
*
1Su
by . In this case theie is also no switching to the alteinative foiecasting
iule.
We show the iesults of these two exeicises in figuies 8.4 anu 8.S. Let us
concentiate on figuie 8.4 fiist, showing the uegiee of macioeconomic volatility
in a iegime of 1uu% cieuibility of the inflation taiget. A fiist thing to note is that
in the iegime of full cieuibility of the inflation taiget the volatility of the output,
inflation anu stock piices is significantly lowei than in the iegime of impeifectly
cieuible inflation taiget. The uiffeience is quite high. Compaiing figuie 8.4 with
figuie 8.S shows that in a fully cieuible inflation taigeting iegime the stanuaiu
ueviation of output, inflation anu stock piices aie about half as laige as in the
case of impeifect cieuibility. Thus, cieuibility is extiemely valuable. It allows
ieuucing the volatility of all thiee macioeconomic vaiiables, at no appaient cost.
This iesult is veiy much in line with the iesults obtaineu in chaptei S.
A seconu conclusion fiom a compaiison of figuies 8.4 anu 8.S is that milu foims
of leaning against the winu in the stock maiket have a much stiongei effect in
ieuucing volatility of output, inflation anu stock piices when cieuibility is
peifect. Thus, cieuibility of the inflation taiget makes leaning against the winu
in the stock maikets moie effective in ieuucing macioeconomic volatility. (Note
again that this only holus foi ielatively low levels of c
4
).
The impoitance of cieuibility as a means to achieving macioeconomic stability
anu as a way to making leaning against the winu in the stock maiket an
effective stabilization tool is ieinfoiceu by the iesults of figuie 8.S. These show
that when theie is total absence of cieuibility in the inflation taiget, the volatility
of output, inflation anu stock piices is highei foi all values of c
4
. In auuition,
leaning against the winu in the stock maiket, now has almost no stabilizing
piopeities foi output anu inflation (compaie figuie 8.S with figuie 8.S).




1
=
t
ext
t
E t
1S1
Figure8.4:Macroeconomicvolatilitywheninflationtargetis100%
credible

Figure8.5:Macroeconomicvolatilitywheninflationtargetis0%credible

8.5.Thetradeoffbetweenoutputandinflationvariability
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
0.01
0.0105
0.011
0.0115
0.012
0.0125
0.013
0.0135
0.014
0.0145
0.015
leaning against stock price c4
s
t
d

o
u
t
p
u
t
standard deviation output
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
0.008
0.0085
0.009
0.0095
0.01
0.0105
0.011
0.0115
0.012
leaning against stock price c4
s
t
d

p
standard deviation inflation
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
0.1
0.12
0.14
0.16
0.18
0.2
0.22
0.24
0.26
0.28
leaning against stock price c4
s
t
d

s
t
o
c
k

p
r
i
c
e
standard deviation stock prices
0 0.02 0.04 0.06 0.08 0.1 0.12
0.018
0.019
0.02
0.021
0.022
0.023
0.024
0.025
leaning against stock price c4
s
t
d

o
u
t
p
u
t
standard deviation output
0 0.02 0.04 0.06 0.08 0.1 0.12
0.03
0.035
0.04
0.045
0.05
0.055
leaning against stock price c4
s
t
d

p
standard deviation inflation
0 0.02 0.04 0.06 0.08 0.1 0.12
0.26
0.28
0.3
0.32
0.34
0.36
0.38
0.4
0.42
0.44
0.46
leaning against stock price c4
s
t
d

s
t
o
c
k

p
r
i
c
e
standard deviation stock prices
1S2
Anothei way to evaluate leaning against the winu stiategies in the stock
maikets is to analyze how they affect the tiaueoff between output anu inflation
vaiiability. We will pioceeu as follows. We ietuin to the iegime of impeifectly
cieuible inflation taiget. We assume seveial values of c
4
fiom u to u.uS (the
leaning against the winu paiametei in the stock maiket). We then compute the
tiaueoffs between output anu inflation vaiiability in the same way as we uiu in
chaptei S
2u
. We plot the iesults in figuies 8.6.
A fiist impoitant finuing conceins the shape of these tiaueoffs. As in chaptei S,
we finu that these tiaueoffs aie nonlineai, i.e theie is a positively anu a
negatively slopeu segment. It is woith iepeating the inteipietation heie. When
the cential bank uoes not caie about output stabilization (c
2
=u) we aie locateu in
the uppei iight points of the tiaueoffs. An inciease in the willingness to stabilize
output (c
2
incieases) leaus to a uownwaiu movement along the tiaueoff. This
means that when the cential bank incieases its output stabilization effoit it
ieuuces both the vaiiability of output anu inflation. At some point, howevei,
applying moie stabilization (c
2
incieases fuithei) biings us in the upwaiu
sloping pait. Fiom then on moie stabilization leaus to the tiauitional tiaueoff:
moie output stability is bought by moie inflation vaiiability. This is the stanuaiu
iesult obtaineu in iational expectations mouels (see chaptei 1). In these mouels
any attempt to stabilize output leaus to moie inflation vaiiability. In oui
behavioial mouel this is not necessaiily the case. Nilu foims of output
stabilization (low c
2
) have the effect of ieuucing both output anu inflation
vaiiability. When howevei the ambition to stabilize output is too stiong, we
ietuin to the tiauitional negatively slopeu tiaueoff anu the gain in output
stabilization leaus to moie inflation vaiiability. Thus, in oui mouel some output
stabilization is always bettei than no stabilization at all. This iesult comes fiom
the stiuctuie of oui mouel. When the cential bank applies mouest output
stabilization it also ieuuces the coiielation of biaseu beliefs anu the ensuing
waves of optimism anu pessimism. The lattei affect not only output vaiiability

20
i.e. we allow the output stabilization parameter (c
2
) in the Taylor rule to increase from 0 to 1 and
compute the standard deviations of output and inflation for each value of c
2
. Note that the output
stabilization coefficient has much larger values than the stock price coefficient (c
4
) . This has to do
with the fact that the variations in stock prices per unit of time are a multiple of the variations in the
output gap.
1SS
but also inflation vaiiability. Thus by ieuucing these animal spiiits the cential
bank achieves both lowei output anu inflation vaiiability. It can uo this because
it piofits fiom a cieuibility bonus. Too much activism, howevei, uestioys this
cieuibility bonus, leauing to the noimal negatively slopeu tiaueoffs.
A seconu finuing fiom Figuie 8.6 ielates to the effect of leaning against the
winu in the stock maiket. We finu that a moie intense leaning against the
winu in the stock maiket impioves the tiaueoffs, i.e. shifts them uownwaius.
Thus leaning against the winu ieuuces both output anu inflation vaiiability.
Note, howevei, that this iesult only holus in the positively slopeu segment of the
tiaueoffs. In the negatively slopeu pait, theie is no cleai effect of leaning against
the winu stiategies. This suggests that leaning against the winu stiategies aie
effective in ieuucing both output anu inflation vaiiability foi the same ieason as
output stabilization uoes. These stiategies tenu to ieuuce the scope foi waves of
optimism anu pessimism anu thus stabilize the macioeconomy as a whole. A too
aggiessive use of these stiategies, howevei, will tenu to cieate an inflationaiy
bias, which then ieestablishes the negative tiaueoff between output anu inflation
vaiiability.
As in the pievious section we analyzeu the impoitance of the cieuibility of
inflation. We uo this by assuming the same two extieme iegimes, peifect
cieuibility anu zeio cieuibility. The peifect cieuibility case is shown in figuie 8.7.
It confiims some of the iesults obtaineu eailiei. Foi example, the tiaueoffs unuei
peifect cieuibility aie locateu much lowei than those obtaineu unuei impeifect
cieuibility (compaie figuie 8.7 with figuie 8.6). Thus, cieuibility uiamatically
impioves the tiaueoffs, leauing to less vaiiability of both output anu inflation.
We also finu that leaning against the winu stiategies impiove these tiaueoffs
significantly, thus loweiing both output anu inflation vaiiability.
The case of zeio cieuibility of inflation taiget is shown in figuie 8.8. The contiast
with the pievious figuies is stiiking. The tiaueoffs aie locateu highei than in the
pievious two cases, anu the positive segments of the tiaueoffs have piactically
uisappeaieu. This has to uo with the fact that in the absence of any cieuibility in
the inflation taiget, agents quickly punish the cential bank by extiapolating the
highei inflation that iesults fiom active stabilization policies. We also concluue
1S4
fiom figuie 8.8 that leaning against the winu stiategies have no visible impact
on the tiaueoffs. Thus policies aiming at ieuucing the volatility of asset piices by
manipulating the inteiest iates uo not impiove macioeconomic stability when
inflation taigeting has no cieuibility.

Figure8.6:Tradeoffoutputandinflationvariability:imperfectcredibility

Figure8.7:Tradeoffoutputandinflationvariability:perfectcredibility

Figure8.8:Tradeoffoutputandinflationvariability:zerocredibility
0.01 0.012 0.014 0.016 0.018 0.02 0.022 0.024
0.0285
0.029
0.0295
0.03
0.0305
0.031
0.0315
std output
s
t
d

i
n
f
l
a
t
i
o
n
tradeoff output-inflation (c1=1.2)


c4=0
c4=0.01
c4=0.02
c4=0.03
c4=0.04
c4=0.05
0.006 0.008 0.01 0.012 0.014 0.016 0.018 0.02
0.0075
0.008
0.0085
0.009
0.0095
0.01
0.0105
0.011
0.0115
0.012
std output
s
t
d

i
n
f
l
a
t
i
o
n
tradeoff output-inflation (c1=1.2)


c4=0
c4=0.01
c4=0.02
c4=0.03
c4=0.04
c4=0.05
1SS



8.6Conclusion
Shoulu cential banks use theii inteiest iate instiument to influence the asset
piices anu to pievent bubbles fiom emeiging. Economists have hotly uebateu
this question. It has become topical again since the cieuit ciisis eiupteu in
August 2uu7. We analyzeu this question using oui behavioial macioeconomic
mouel. This mouel piouuces booms anu busts that aiise fiom the fact that biaseu
beliefs about the futuie become coiielateu (animal spiiits). As we showeu in this
chaptei, the inteiaction of booms anu busts in the stock maiket anu in the goous
maikets tenus to inciease macioeconomic volatility in output anu inflation. It is
theiefoie quite legitimate to analyze the question of whethei the cential bank
shoulu take stock piice movements into account when ueciuing about monetaiy
policies.
0ui main iesults aie the following. Yes, cential banks can influence stock piices,
anu by following leaning against the winu stiategies in the stock maiket, they
can impiove the tiaueoff between output anu inflation, i.e. they can ieuuce the
volatility of both output anu inflation. They achieve this iesult because they help
to ieuuce the coiielation in biaseu beliefs anu the ensuing booms anu busts. This
iesult, howevei, only holus in an enviionment of cieuible inflation taigeting. If
the inflation taiget has a high uegiee of cieuibility we finu that these leaning
0.014 0.015 0.016 0.017 0.018 0.019 0.02 0.021 0.022 0.023 0.024
0.033
0.0332
0.0334
0.0336
0.0338
0.034
0.0342
0.0344
0.0346
0.0348
0.035
std output
s
t
d

i
n
f
l
a
t
i
o
n
tradeoff output-inflation (c1=1.2)


c4=0
c4=0.01
c4=0.02
c4=0.03
c4=0.04
c4=0.05
1S6
against the winu stiategies significantly impiove macioeconomic stability
(output anu inflation stability). Bowevei, these policies aiming at ieuucing the
volatility of asset piices by manipulating the inteiest iates uo not impiove
macioeconomic stability when inflation taigeting has no cieuibility.
Thus theie is a giain of tiuth in the two schools of thought about the uesiiability
of taigeting stock piices. As mentioneu eailiei, the fiist school of thought
stiesses the impoitance of piice stability. 0ui iesults confiim this insight. At the
same time, oui iesults also confiim the insights of the seconu school of thought
stiessing that cential banks can anu shoulu tiy to influence asset piices as pait of
theii stiategy of minimizing macioeconomic volatility.
0ne limitation of the piesent analysis is that this chaptei consiueis the use of
only one instiument, the inteiest iate, foi influencing inflation, output anu asset
piices. Nouein cential banks, howevei, have othei instiuments at theii uisposal
that they coulu use to affect asset piices. These auuitional instiuments incluue
minimum ieseive iequiiements anu othei tools to affect the banks capacity to
lenu
21
. The use of auuitional instiuments woulu facilitate achieving both piice
stability anu stability in asset piices.



21
See De Grauwe and Gros(2009) who propose a two-pillar strategy for central banks. One pillar
would consist in using the interest rate to target inflation and output and another pillar that would use
reserve requirements to target bank loans. The latter are often the driving forces behind the bubbles in
asset prices (see Borio and White(2004) on this).
1S7
















CHAPTER9:EXTENSIONSOFTHEBASICMODEL















1S8
1. Introduction

The behavioial mouel uevelopeu in the pievious chapteis useu veiy simple
heuiistics. Agents who aie foiecasting the output gap weie eithei
funuamentalists oi extiapolatois. The use of these simple iules alloweu us to
ueiive poweiful iesults. The issue that aiises, howevei, is whethei these iesults
aie not too uepenuent on the specific iules useu. Put uiffeiently, if we hau useu
othei iules, woulu we still have obtaineu the same oi similai iesults. This is the
issue of the iobustness of the iesults. The pioblem of the iobustness of the
iesults in a behavioial mouel is quite funuamental. It uoes not occui in the same
way in the mainstieam mouels with full iational behavioi because theie is only
one way to be iational. 0nce we uepait fiom full iationality, theie aie many ways
one can mouel this uepaituie(see Bollanu anu Nillei(1991)) on this.
The way we will analyze this issue is by intiouucing othei iules (heuiistics)
assuming the same type of selection mechanism between these iules as the one
we have been using up to now. Thus we extenu the menu of simple iules agents
can use anu analyze how these new menu affects the iesults.

2. Fundamentalistsarebiased

The behavioial mouel assumes that the funuamentalists know the equilibiium
value of the output gap anu use this knowleuge to make foiecasts. We will now
uiop this assumption anu insteau take the view that funuamentalists who uo not
obseive the equilibiium output gap aie unceitain about the tiue value of the
output gap.
It is useful heie to pause again anu to think about the meaning of unceitainty.
0sing the uistinction intiouuceu by Fiank Knight (see chaptei S), unceitainty has
two meanings. The fiist one is unceitainty in the sense of iisk. This is the
unceitainty that can be quantifieu anu that allows agents to make piobabilistic
statements baseu on a statistical analysis of past movements of the output gap.
This is the meaning to unceitainty given in stanuaiu macioeconomic mouels. In
such a mouel agents will uo a statistical analysis of past movements of the output
gap anu base theii foiecasts on a continuous upuating of the statistical
infoimation.
1S9
The seconu meaning of unceitainty is an unceitainty that cannot be quantifieu
anu that theiefoie uoes not allow agents to make piobabilistic statements. This
is the meaning of unceitainty that we will use heie. Agents in oui mouel take the
view that the movements of the output gap aie not noimally uistiibuteu anu that
theie is too much fat tail iisk that they cannot quantify (see chaptei S on this).
They theiefoie use simple but biaseu heuiistics to estimate the equilibiium
output gap.
We will assume the simplest possible heuiistic. This is that some agents aie ovei
optimistic in estimating the equilibiium output gap, i.e. they exhibit an optimistic
bias; othei agents aie too pessimistic anu exhibit a pessimistic bias. We now
obtain the following equations:
The optimistic funuamentalist iule (fo) is uefineu by (9.1)
The pessimistic funuamentalist iule (fp) is uefineu by (9.2)
wheie a is a positive constant.
Thus the optimists systematically oveiestimate the equilibiium output gap while
the pessimists systematically unueiestimate it. We assume that the bias is
symmetiical.
We subject these two iules to the same selection mechanism as in the basic
behavioial mouel. Since we also have an extiapolative iule, which was uefineu as
(9.S)
we obtain a mouel with thiee iules.
As befoie, a selection mechanism is assumeu, wheieby agents can switch
between the thiee iules. This implies fiist that agents compute the peifoimance
(utility) of using these iules as in chaptei S:
Peifoimance of optimistic funuamentalist iule:
Peifoimance of pessimistic funuamentalist iule:
Peifoimance of extiapolative iule:


E
t
fo
y
t +1
= a

E
t
fp
y
t +1
= a

E
t
e
y
t +1
= y
t 1
U
fo,t
= e
k
k =1

y
t k


E
fo,t k 1
y
t k
| |
2
U
fp,t
= e
k
k =1

y
t k


E
fp,t k 1
y
t k
| |
2
U
e,t
= e
k
k =1

y
t k


E
e,t k 1
y
t k
| |
2
14u
The coiiesponuing piobabilities of using the thiee iules now aie:

(9.4)

(9.S)

(9.6)


Thus insteau of having only two foiecasting iules, we now have thiee iules
among which agents will select the one that has the best peifoimance.
The extenueu mouel was simulateu in the time uomain using the same
calibiation as in chaptei S. The iesults of a typical simulation in the time uomain
aie shown in figuie 9.1. The fiist panel shows the fluctuations in the output gap.
We now obtain fluctuations that aie moie pionounceu anu piotiacteu than in
the twoagent mouel of chaptei S. This has to uo with the fact that the animal
spiiits (the waves of optimism anu pessimism) aie moie pionounceu. We now
ieuefine animal spiiits to consist of the sum of the fiactions of optimistic
funuamentalists anu positive extiapolatois. These now ieinfoice each othei
piouucing stiongei waves of optimism an pessimism. This is shown in the
seconu panel of Figuie 9.1.
In oiuei to show the natuie of the fluctuations in the output gap we also piesent
the fiequency uistiibutions of the output gap anu animal spiiits. These aie
shown in figuie 9.2. The iesults contiast with those obtaineu in the basic mouel
in that the fat tails in the output gap movements aie now moie pionounceu. The
oiigin of these stiongei fat tails is to be founu in the much highei concentiation
of obseivations of animal spiiits aiounu u (extieme pessimism) anu 1 (extieme
optimism). Thus the biases (optimistic oi pessimistic) in the funuamentalists
estimations of the equilibiium output gap togethei with the existence of
extiapolatois have the effect of ieinfoicing waves of optimism anu pessimism,
piouucing movements in the output gap that ueviate even fuithei fiom the
noimal uistiibution than in the simple twoagent mouel of chaptei S.
o
fo,t
=
exp U
fo,t
( )
exp(U
fo,t
) + exp(U
fp,t
) + exp(U
e,t
)
o
fp,t
=
exp U
fp,t
( )
exp(U
fo,t
) + exp(U
fp,t
) + exp(U
e,t
)
o
e,t
=
exp U
e,t
( )
exp(U
fo,t
) + exp(U
fp,t
) + exp(U
e,t
)
141
Figure9.1:Outputgapandanimalspiritsinthreeagentmodel



Figure9.2Frequencydistributionofoutputgapandanimalspirits



The iesults obtaineu foi inflation aie similai as in chaptei S. We obseive peiious
of tianquility (gieat moueiation) in the movements of inflation (see Figuie 9.S).
Buiing these peiious inflation iemains veiy close to the inflation taiget set by
142
the cential bank (+ oi 1%). But suuuenly inflation can tenu to ueviate
substantially fiom the taiget. This happens when the inflation extiapolatois tenu
to uominate the maiket. In this mouel these ueviations aie always tempoiaiy
because the cential bank uses the Tayloi iule anu thus incieases the inteiest iate
when inflation incieases anu viceversa.

Figure9.3Inflationinthethreeagentmodel



3. Shocksandtradeoffs

Bow uoes the thieeagent mouel peifoim when it is subjecteu to exogenous
uistuibances. We analyze this question now, anu compaie oui iesults to those
obtaineu in the basic mouel. We subjecteu the mouel to a positive piouuctivity
shock anu computeu the impulse iesponse of the output gap anu inflation. In
Figuie 9.4 we piesent the iesults anu we also compaie these with the impulse
iesponses obtaineu (unuei the same conuitions) in the basic mouel.
0n the whole we obtain veiy similai impulse iesponses in the thieeagent mouel
as compaieu to the basic mouel. In both mouels the piouuctivity shock leaus to
an inciease in the output gap anu a uecline in inflation. In both cases theie is
consiueiable unceitainty about how the piouuctivity shock is tiansmitteu into
the economy. We uiscusseu this featuie in chaptei 4. It has to uo with the fact
that the mouel is sensitive to initial conuitions. Biffeient initial conuitions
(maiket sentiments) affect how the same shock is tiansmitteu to the economy.
Fiom a compaiison of the left anu iight hanu siue panels in Figuie 9.4 we finu
14S
that the unceitainty is even moie pionounceu in the thieeagent mouel than in
the basic mouel. This has to uo with the fact that the thieeagent mouel piouuces
stiongei waves of optimism anu pessimism (animal spiiits) than the basic mouel
anu stiongei ueviations fiom noimality.

Figure9.4Impulseresponsesofoutputgapandinflationtoproductivity
shock

Threeagentmodel Basicmodel







Finally we also calculate the tiaueoffs in oui thieeagent mouel in the same way
as was uone in chaptei S. We finu the same nonlineaiity in the tiaueoffs as in
the basic mouel. We inteipieteu this nonlineaiity to mean that theie is scope foi
active stabilization of the output gap. This is the iange in which the tiaueoff has
144
a positive slope. In that iange the cential bank can by stabilizing output impiove
both inflation anu output stability. This woiks up to a point though. Too much
output stabilization will biing us into the negatively slopeu iange in which any
fuithei attempt at stabilizing output leaus to moie inflation volatility. This point
is ieacheu when the Tayloi output coefficient is incieaseu above u.S
(appioximately). In geneial, when compaiing the tiaueoff obtaineu in Figuie 9.S
with the tiaueoffs of chaptei S we finu that the nonlineaiity is even moie
pionounceu.
We also obtain the iesult of the basic mouel, which is that by ieacting moie
stiongly to inflation (an incieasing Tayloi inflation paiametei, c1) the tiaueoff
impioves (shifts uownwaius). This suggests that in this veision of the behavioial
mouel cential banks can ieuuce both inflation anu output volatility by keeping
inflation close to its taiget.
Thus, oveiall the extension of the mouel to a iichei menu of simple foiecasting
iules has kept the main iesults of the behavioial mouel pietty much unchangeu.
In fact this extension has intensifieu the uepaituie fiom the mainstieam iational
expectations mouels in uiffeient uiiections. It incieases the uepaituies fiom
noimality of the movements of the output gap. The main ieason is that it
intensifies the movements of animal spiiits. This has the effect of cieating moie
unceitainty about how exogenous shocks aie tiansmitteu into the economy, anu
cieates moie scope foi output stabilization, without howevei ieuucing the neeu
to maintain a cieuible inflationtaigeting iegime.


14S
Figure9.5:Tradeoffbetweeninflationandoutputvariability


4. Furtherextensionsofthebasicmodel
Theie aie many moie possible extensions of the mouel once we allow foi
uiffeient foiecasting iules. In this section we piesent some iesults of an
extension in anothei uiiection. In the pievious mouels we assumeu that agents
use an extiapolative iule. We now uiop this assumption anu take the view that
all agents use funuamentalist iules. We now consiuei thiee iules, an optimistic, a
pessimistic iule anu a neutial one. Thus some agents use biaseu iules (eithei
optimistic oi pessimistic) anu otheis use an unbiaseu estimate of the equilibiium
output gap. The thiee iules become:







The iesults of simulating this mouel aie shown in figuies 9.6 anu 9.7.

E
t
fo
y
t +1
= a

E
t
fp
y
t +1
= a

E
t
n
y
t +1
= 0
146
Figure9.6:output,animalspiritsandinflation




147
Figure9.7:Frequencydistributionofoutputgapandanimalspirits





This mouel piouuces similai iesults as the basic twoagent mouel, with animal
spiiits uiiving the cyclical movements in output. The lattei, howevei, aie less
pionounceu than in the pievious thieeagent mouel. This has much to uo with
the fact that in the piesent veision of the thieeagent mouel theie aie agents
who have an unbiaseu view of the equilibiium output gap. These agents have a
stabilizing influence on the fluctuations of output anu inflation. Whethei such
agents exist in ieality is anothei mattei.



148
5. Conclusion
In this chaptei we eniicheu the menu of iules that agents can use to make
foiecasts. We kept the same stiuctuie about how these iules aie selecteu as in
the pievious chapteis. We founu that most of the iesults ueiiveu in the pievious
chapteis aie iobust aie maintaineu.
0f couise, one coulu go on extenuing the menu of possible heuiistics that agents
can use. Some extensions aie suiely necessaiy. Foi example, one woulu like to
know how iobust the mouel is when the numbei of iules becomes veiy laige.
Also, we have systematically piesenteu the iules as a given menu fiom which
agents can choose. But it is also possible foi agents to cieate new iules anu to
expeiiment with these. This has not been uone heie. It is an aiea foi fuithei
ieseaich. Such an extension woulu also ieveal that the concept of equilibiium
fiom classical mouels cannot easily be maintaineu.
It shoulu also be mentioneu that theie is now a buigeoning liteiatuie on agent
baseu mouels that use a laige numbei of agents with a laige menu of heuiistics.
This liteiatuie was veiy much influenceu by the eaily woik of Shelling(1969)
anu Axeliou(1997). It has founu incieasing applications in economics (see
Naiimon, et al.(199u), Belli uatti, et al.(2uuS), Colanuei et al. (2uu8),
Faimei(2uu8), LeBaion anu Tesfatsion(2uu8)). The common chaiacteiistic of
these mouels is that they consist of autonomous agents following simple iules of
behavioi anu inteiacting with many othei agents piouucing complex outcomes.
This is also the setup we useu heie. It is to be expecteu that new anu exciting
iesults will emeige fiom this liteiatuie.


149













Chapter10:EmpiricalIssues

1Su
1.Introduction

A theoietical mouel can only convince if it passes some foim of empiiical testing.
This is also the case with the behaviouial mouel uiscusseu in this book. The
pioblem in macioeconomics is how to uevise a cieuible empiiical test of the
mouel. The histoiy of macioeconomics is litteieu with examples of mouels which
passeu econometiic testing pioceuuies with flying colois, to be founu wanting
latei. The BSuEmouels aie no exceptions to this iule.
The empiiical testing tiauition in macioeconomics has consisteu in estimating an
econometiic mouel that embouies the equations of the theoietical mouel anu
then to peifoim uynamic simulations given the exogenous vaiiables. Neasuies of
goouness of fit then alloweu the ieseaichei to ueciue about the empiiical valiuity
of the theoietical mouel.
This appioach is now seveiely ciiticiseu. Fiist, it uoes not pass the Lucas ciitique
as the estimateu paiameteis of the stiuctuial mouel aie not invaiiant to the
policy iegime (Lucas(1976)). Seconu, an attempt to estimate a smallscale mouel,
as the one piesenteu in this book, is likely to encountei pioblems of missing
vaiiables anu incomplete uynamics. This is likely to leau to a misspecifieu mouel.
Some ieseaicheis have ieacteu to this by auuing autoiegiessive piocesses in the
eiioi teims as a cheap way to ueal with these specification eiiois. We have
aigueu that some of the existing BSuEmouels suffei fiom this pioblem. This
appioach is not attiactive. The main ieason is that is uoes not allow us to finu out
whethei the mouel is iejecteu by the uata oi not (see }uselius anu
Fianchi(2uu7)). We will theiefoie not tiy to uo this.
We will follow the appioach of inuiiect infeience, i.e. we ask the question what
the pieuictions of the theoietical mouel aie anu confiont these pieuictions with
the uata. 0f couise, it shoulu be stiesseu fiom the stait that a lot of unceitainty
will continue to pievail about the empiiical valiuity of the behaviouial mouel.
Let us list the main pieuictions of the behaviouial mouel.
1. 0utput movements aie coiielateu with measuies of optimism anu pessimism
2. 0utput movements aie not noimally uistiibuteu anu show fat tails.
1S1
S. Inteiest iate inciease leaus to tempoiaiy uecline in output anu inflation (like
in othei mouels). These effects, howevei, aie time uepenuent (uepenu on
maiket sentiments). This leaus to uiffeient impulse iesponses uepenuing on
the time of the shock.
We now check whethei these thiee pieuictions aie coiioboiateu by empiiical
eviuence.

2.Thecorrelationofoutputmovementsandanimalspirits
The concept of animal spiiits, i.e. waves of optimism anu pessimism, has playeu a
cential iole in the behavioial macioeconomic mouel piesenteu in the pievious
sections. The fiist question that aiises heie is whethei theie is an empiiical
counteipait foi this concept. Theie is one, anu it is wiuely useu in uaytouay
macioeconomic analysis. Nany countiies use suivey baseu consumei anuoi
business sentiment inuicatois as a tool of analyzing the business cycle anu as a
pieuictive instiument.
The bestknown sentiment inuicatoi in the 0S is the Nichigan Consumei
Confiuence inuicatoi, which has been in use since the 19Sus. The fiist measuies
of consumei confiuence weie uevelopeu by ueoige Katona in the late 194us (see
Katona(19S1)). Since then similai inuicatois have been implementeu in a laige
numbei of countiies (see Cuitin(2uu7) foi an evaluation). Typically, sentiment
inuicatois aie constiucteu on the basis of a numbei of questions of how the
inuiviuual peiceives the piesent anu the futuie economic conuitions. Thus, these
suiveys piouuce two inuices, one conceining piesent conuitions, anu one about
futuie economic conuitions. I will concentiate on the lattei heie, because this
comes closest to the concept of optimism anu pessimism useu in this book, which
is foiwaiu looking. The stiuctuie of these questions usually piesents the
inuiviuual with a uisciete choice between gooubauneutial. An example fiom
the Nichigan inuicatoi is the question: Bo you think that uuiing the next twelve
months, well have goou times financially oi bau times oi what. |goou
timesunceitainbau timesj. The answeis aie then tiansfoimeu into an inuex
by computing the uiveigence between goou times anu bau times answeis.
1S2
The question that is auuiesseu in this section is to what extent these sentiment
inuicatois behave in a way that is consistent with oui behavioial macioeconomic
mouel. In figuie 1u.1 the Nichigan Consumei Confiuence inuicatoi is shown,
togethei with the 0S output gap (quaiteily uata) uuiing 197u2uu9. The
coiielateu movements of the sentiment inuex anu the output gap aie stiiking.
The coiielation coefficient was founu to be u.6. Note that in the simulations
iepoiteu in chaptei S the coiielation coefficient between the output gap anu the
fiaction of optimists was typically aiounu u.8S. The lowei coiielation obseiveu
in ieality is ielateu to the fact that the suivey baseu sentiment inuicatois anu the
output gap have a lot of noise.
A typical featuie of this coiielation in the theoietical mouel is that the causality
goes both ways, i.e. animal spiiits affect output anu output feeus back on animal
spiiits. We illustiateu this by peifoiming a uiangei causality test on the
simulateu output gaps anu the fiactions of optimists obtaineu fiom the basic
behavioial mouel of chaptei S (see table 1u.1). It shows that one cannot ieject
the hypotheses that animal spiiits uiangei cause the output gap anu that the
output gap uiangei causes the animal spiiits. Can one finu the same stiuctuie in
the ielation between the obseiveu uBP giowth iates anu the Nichigan Consumei
Confiuence inuicatoi. The answei is pioviueu in table 1u.2. It shows that one
cannot ieject the hypothesis that the Nichigan Consumei Confiuence inuicatoi
uiangei causes the 0S output gap anu that the 0S output gap uiangei causes the
Nichigan Confiuence inuicatoi. Cuitin(2uu7) has shown that in a sample of moie
than Su countiies in a majoiity of these countiies one finus twoway causality
between the confiuence inuicatoi anu uBP giowth (oi anothei pioxy foi the
business cycle).
1SS
Figure10.1:USoutputgapandMichigansentimentindex(19702009)

Souice: 0S Bepaitment of Commeice, Buieau of Economic Analysis, anu

0niveisity of Nichigan: Consumei Sentiment Inuex.

Table 10.1: Pairwise Granger Causality Tests: behavioral model
Null Hypothesis: Obs F-Statistic Probability
Output does not Granger Cause optimism 1948 31.0990 5.1E-14
Optimism does not Granger Cause output 32.8553 9.3E-15


Table 10.2: Pairwise Granger Causality Tests: US data (1970-2009)
Null Hypothesis: Obs F-Statistic Probability
MICHIGAN does not Granger Cause GDP 123 15.83 0.00001
GDP does not Granger Cause MICHIGAN 4.83 0.0096
Souice: calculateu fiom 0S Bepaitment of Commeice, Buieau of Economic
Analysis, anu 0niveisity of Nichigan: Consumei Sentiment Inuex.

0,1
0,08
0,06
0,04
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0
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i
c
h
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a
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i
n
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e
x
USOutputgapandMichigansentimentindex
Michigan
output gap
o
u
t
p
u
t

g
a
p
1S4
3.Modelpredictions:highermoments

In chaptei S we showeu that the behavioial mouel pieuicts that the output gap is
not noimally uistiibuteu anu exhibits fat tails. This featuie of the highei
moments of the output gap is geneiateu enuogenously in the mouel. It is not the
iesult of imposing such a featuie on the stochastic shocks hitting the economy.
We inteipieteu this iesult to mean that the mouel pieuicts that occasionally
extieme movements in output can occui as a iesult of an enuogenous uynamics.
In chaptei S we alieauy confionteu this pieuiction with uata fiom the 0S anu
concluueu that inueeu the uistiibution of the 0S output gap uuiing the postwai
peiiou was not noimal. In this section we look at othei countiies, i.e. the 0K anu
ueimany. 0nfoitunately the sample peiiou is shoitei anu only staits in 199u. Foi
the sake of compaiability we also piesent the 0S uata foi this shoitei peiiou. The
iesults aie shown in Figuies 1u.2 to 1u.4. They confiim what we founu eailiei,
the output gap in these countiies is not noimally uistiibuteu (see }aiqueBeia
test which ieject noimality), anu it exhibits fat tails. The lattei means that the
output gap is occasionally subjecteu to laige changes that woulu not be obseiveu
if they weie noimally uistiibuteu.
0ne coulu object to this empiiical analysis that the laige shocks obseiveu in the
output gaps can also be the iesult of laige exogenous shocks. In othei woius, the
eviuence pioviueu in figuies 1u.2 to 1u.4 is also consistent with the view
(implicit in BSuEmouels) that the macioeconomy uoes not piouuce laige (non
noimally uistiibuteu) shocks, anu thus that the obseiveu laige movements in
output gaps must come fiom outsiue the mouel. Put uiffeiently, in the BSuE
woilu laige movements in output must be the iesult of laige exogenous shocks.
1SS
Figuie 1u.2: Fiequency uistiibution of 0S output gap

Figuie 1u.S: Fiequency uistiibution of 0K output gap

Figuie 1u.4: Fiequency uistiibution of ueiman output gap

Souice: 0ECB


0
2
4
6
8
10
12
14
16
-0.075 -0.050 -0.025 0.000 0.025
Series: USGAP
Sample 1990:1 2009:4
Observations 80
Mean -0.006394
Median -0.004803
Maximum 0.041474
Minimum -0.070291
Std. Dev. 0.021906
Skewness -0.599819
Kurtosis 4.360329
J arque-Bera 10.96542
Probability 0.004158
0
1
2
3
4
5
6
7
8
9
-4 -3 -2 -1 0 1
Series: UK
Sample 1991:1 2007:4
Observations 68
Mean -0.836548
Median -0.519114
Maximum 1.375667
Minimum -4.347250
Std. Dev. 1.368099
Skewness -0.848991
Kurtosis 3.128224
J arque-Bera 8.215495
Probability 0.016445
0
2
4
6
8
10
-3 -2 -1 0 1 2 3
Series: DE
Sample 1991:2 2007:4
Observations 67
Mean -1.140230
Median -1.365473
Maximum 2.893201
Minimum -3.279188
Std. Dev. 1.242444
Skewness 0.960223
Kurtosis 3.823937
J arque-Bera 12.19116
Probability 0.002253
1S6
The claim that is maue heie is not that the economy cannot sometimes be hit by
laige shocks, but that a theoiy that claims that laige movements in output can
only occui because of exogenous shocks is not a poweiful theoiy. It necessitates
finuing a new exogenous explanation foi eveiy laige boom anu bust obseiveu in
output
22
. Put uiffeiently, foi eveiy boom oi eveiy bust a new stoiy has to be tolu.
Such a theoiy has veiy little pieuictive powei. It amounts to a sophisticateu
stoiytelling exeicise. 0ui theoiy allows foi an explanation that is geneiateu
within the mouel. It is, theiefoie, moie poweiful.

4. Transmissionofmonetarypolicyshocks
Empiiical testing in macioeconomics has been veiy much influenceu by
Sims(198u) seminal contiibution (see Faveio(2uu1) on this)). The basic iuea is
that theoietical mouels make pieuictions about the effects of policy shocks anu
that these pieuictions can be confionteu with the uata. The ways this can be
uone is to estimate a vAR of the macioeconomic vaiiables anu the policy
vaiiable. In the context of oui mouel this consists in estimating a vAR of inflation,
output gap anu the inteiest iate. This vAR then allows to estimate an impulse
iesponse of inflation anu output gap on inteiest iate shocks. This impulse
iesponse obtaineu fiom the uata is then compaieu with the impulse iesponse
pieuicteu by the theoietical mouel. It is impoitant that, in uoing so, the empiiical
impulse iesponse is theoiyfiee, i.e. uoes not use theoiy to impose iuentifying
iestiictions. Aftei all, this appioach is baseu on the iuea of confionting
theoietical pieuictions of the effect of a policy shock on inflation anu output with
the impulse iesponse of inflation anu output following a policy shock as uetecteu
fiom the uata. In piactice, this is not always easy to uo, because iestiictions on
the paiameteis of the vAR must be imposeu to be able to iuentify the impulse
iesponses. The conuition theiefoie has been to impose iestiictions that use the
least possible theoiy, oi put uiffeiently, that aie useu in the laigest possible class

22
For an illustration of this approach see Favero(2001), p. 73-75. Favero finds that there are
many outliers in a VAR model of the US economy, but interprets this to be the result of
exogenous shocks (e.g. oil shocks). He then adds many dummies and, no surprise, the errors
become normal.
1S7
of theoietical mouel. The Choleski uecomposition (see e.g. Faveio(2uu1) foi
explanation) is geneially consiueieu as the most theoiyfiee set of iestiictions.
Anothei populai set of inuentifying iestiictions was pioposeu by Blanchaiu
Quah(1989). This consists in imposing iestiictions on the longteim effects of
uemanu anu supply shocks baseu on theoietical insights. The lattei aie that
uemanu shocks (e.g. a monetaiy shock) have only tempoiaiy effects. The
pioblem with the BlanchaiuQuah iestiictions is that they excluue apiioii a
class of mouels that allow foi multiple equilibiia. In these mouels uemanu shocks
can have peimanent effects.
We now confiont the theoietical impulses obtaineu fiom oui behavioial mouel
with the empiiical ones. As a fiist step, we estimateu a vARmouel with thiee
vaiiables (output, inflation anu shoit teim inteiest iate) foi the 0S, using a
Choleski uecomposition (with oiueiing of inflation, output, inteiest iate). We
then computeu the impulse iesponses of output to an inciease in the shoitteim
inteiest iate (the Feueial Funus iate). 0ne of the main pieuictions of the
behavioial mouel is that the impulse iesponses aie veiy much influenceu by the
timing of the shock. We testeu the empiiical valiuity of this pieuiction by
computing uiffeient impulse iesponses ovei uiffeient sample peiious. We
alloweu foi iolling sample peiious of Su yeais staiting in 1972, anu moving up
each month. Foi each of these sample peiious we computeu the shotteim output
effect of an inciease in the Feueial Funu iate, wheie shoitteim iefeis to the
effect aftei one yeai. We show the uistiibution of these shoitteim effects in
Figuie 1u.S. We finu a wiue iange of shoittem effects to the same policy shock
(between u.2% anu u.7% foi a 1 stanuaiu ueviation shock in the inteiest iate).
In auuition, we finu that the uistiibution of theses output iesponses is not
noimal. The }aiqueBeia test oveiwhelmingly iejects noimality. We stiesseu in
chapteis S anu 4 that this featuie makes it veiy uifficult foi inuiviuual agents to
make statistical infeiences about the likely effects of a policy shock. 0n the whole
the empiiical iesults confiim the theoietical pieuiction of the behavioial mouel,
i.e. the timing of the shock matteis a gieat ueal anu affects how the same policy
shock is tiansmitteu into the economy. In auuition, the nonnoimality in the
uistiibution of these shocks tiansfoims iisk into unceitainty.
1S8
As in the case of the nonnoimal uistiibution of the output gap, it must be
aumitteu that the eviuence of a nonnoimal uistiibution of the shoitteim output
effects of monetaiy policy shocks is not necessaiily in contiauiction with the
BSuEmouel. In the fiamewoik of that mouel, the eviuence pioviueu heie can be
inteipieteu as aiising fiom changes in policy iegime. It is wellknown since the
famous Lucas ciitique (Lucas(1976)), that changes in policy iegime change the
stiuctuial paiameteis of the stanuaiu uemanu anu supply equations, anu thus
also change the tiansmission of policy shocks (the impulse iesponses). In this
inteipietation, the eviuence of nonnoimal uistiibution of the shoitteim output
effects of a monetaiy policy shock is consistent with the view that theie have
been uiffeient changes in the policy iegime uuiing the sample peiiou. These
changes then piouuce nonnoimal uistiibutions of these effects.

Figure10.5:Distributionshorttermoutputresponsetoshockfedfundrate

Again we have two iauically uiffeient inteipietations of the same empiiical

eviuence (which is not unusual in economics). The claim maue in this book is
that the inteipietation given in the behavioial mouel is simplei than the one
pioviueu in the BSuEmouel. In the lattei, the theoietical mouel pieuicts that
pioviueu the policy iegime uoes not change, a policy shock will always have
the same effect. With noise in the uata, the estimateu effects of these shocks
shoulu be noimally uistiibuteu. If we obseive nonnoimality, this must be
0
4
8
12
16
20
24
-0.7 -0.6 -0.5 -0.4 -0.3 -0.2
Series: OUTPUTRESPONSE
Sample 1 108
Observations 108
Mean -0.458938
Median -0.375850
Maximum -0.215400
Minimum -0.739700
Std. Dev. 0.163445
Skewness -0.514876
Kurtosis 1.705925
J arque-Bera 12.30758
Probability 0.002125
1S9
piouuceu outsiue the mouel, in this case by exogenous changes in the policy
enviionment. Thus foi eveiy ueviation fiom noimality, the BSuEmoueleis
must invoke a special event that has occuiieu outsiue the mouel. Such a
mouel has no pieuictive powei, because ueviations fiom the pieuicteu
noimality is always uue to special ciicumstances. In contiast, in oui
behavioial mouel, nonnoimality of the effects of policy shocks aie not
ueviations fiom the iule, they aie the iule.
We concluue that oui behavioial mouel makes pieuictions that stanu the test
of the confiontation with the uata. This uoes not mean, of couise, that the
empiiical tests uiscusseu heie aie in any way uefinitive. They shoulu be
consiueieu as pieliminaiy tests. Nuch moie empiiical testing will be
necessaiy to elevate the behavioial mouel to the satus of a seiious
alteinative to the mainstieam macioeconomic mouels.

16u
Conclusion

Since its inception, booms anu busts have chaiacteiizeu capitalism. The cential
issue in macioeconomics theiefoie is why these booms anu busts in economic
activity anu in piices occui. Eveiy macioeconomic theoiy must be capable of
explaining these facts.
The explanation given by mainstieam macioeconomics, in paiticulai by New
Keynesian macioeconomics, fails to impiess. In essence the stoiy tolu by the
New Keynesian macioeconomics is that these fluctuations aiise because of laige
exogenous shocks. The lattei have the effect of foicing iational agents to change
theii optimal consumption anu piouuctions plans, but since they cannot aujust
theii plans instantaneously, piices anu output aujust with lags. It is the
combination of exteinal shocks anu slow aujustment that piouuces cyclical
movements.
Thus, why uiu the woilu get into a iecession in 2uu8u9. The answei of the New
Keynesian mouel builueis is that in 2uu7 a laige exteinal shock aiose in the foim
of a suuuen anu unexpecteu inciease in iisk aveision. This change in iisk
peiception then, like a huiiicane, woikeu its way thiough the economy anu
piouuceu a ueep iecession. In this sense mainstieam macioeconomics has
piouuceu a huiiicane theoiy of the business cycle.
The failuie of mainstieam macioeconomics to pioviue an enuogenous
explanation of booms anu busts, in which a bust is the iesult of a pievious boom,
anu a boom the iesult of a pievious bust has eveiything to uo with the
unueilying paiauigm of mainstieam macioeconomics. This is the paiauigm of
the fully infoimeu utility maximizing agent who uoes not make systematic
mistakes. Laige booms oi laige busts can only be cieateu by laige exteinal
shocks to which these iational agents then will ieact.
I have aigueu that we neeu anothei macioeconomics that has the ambition of
ueveloping an enuogenous explanation of the business cycle. I have tiieu to uo so
in this book. This has necessitateu enlaiging the concept of iationality. In
mainstieam macioeconomics iationality is naiiowly uefineu as utility
161
maximization of agents who uo not exhibit cognitive limitations, anu as a iesult
can solve incieuibly complex pioblems of optimization anu infoimation
piocessing. The staiting point of the behavioial mouel piesenteu in this book
was that agents have limiteu cognitive abilities. These limitations foice them to
use simple iules (heuiistics). Rationality was then intiouuceu as a willingness of
agents to leain by switching to alteinative iules in oiuei to impiove theii
peifoimance. Thus, moving away fiom the naiiow iationality concept of
mainstieam macioeconomics uoes not imply that one is conuemneu to mouel
iiiationality wheie eveiything becomes possible.
The attempt to mouel the macioeconomy in an enviionment in which agents
have cognitive limitations, in which they uevelop uiffeient beliefs about the way
the economy functions, anu in which theiefoie waves of optimism anu
pessimism aiise, may oi may not be successful. What is ceitain, howevei, is that
a macioeconomic theoiy that uses a paiauigm of agents with supeiioi cognitive
abilities capable of solving the most complex pioblems is not a plausible theoiy.
Nost impoitantly, as was aigueu in this book, it has faileu empiiically. We aie
thus conuemneu to look foi something else.
162

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