Bounded Rationality in Macroeconomics
People are inattentive, forgetful, and otherwise imperfect decisionmakers. It is well documented that models of choice with cognitive or attentional constraints, or bounded rationality, can capture these realities and explain deviations of individual behavior from a benchmark of pure payoff maximiza...
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| Format: | Thesis |
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Massachusetts Institute of Technology
2022
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| Online Access: | https://hdl.handle.net/1721.1/144513 |
| _version_ | 1811069739777130496 |
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| author | Sastry, Karthik Amrutur |
| author2 | Angeletos, George-Marios |
| author_facet | Angeletos, George-Marios Sastry, Karthik Amrutur |
| author_sort | Sastry, Karthik Amrutur |
| collection | MIT |
| description | People are inattentive, forgetful, and otherwise imperfect decisionmakers. It is well documented that models of choice with cognitive or attentional constraints, or bounded rationality, can capture these realities and explain deviations of individual behavior from a benchmark of pure payoff maximization. This thesis studies the aggregate implications of such imperfect reasoning and decision making for macroeconomic dynamics and policy.
The first chapter, “Attention Cycles” (jointly authored with Joel P. Flynn), studies the causes and consequences of fluctuations in apparent bounded rationality over the business cycle. Using data from US public firms’ regulatory filings and financial statements, we document that firms’ attention to macroeconomic conditions rises in downturns and that their propensity to make input-choice mistakes rises in booms. We explain these phenomena with a business-cycle model in which firms face a cognitive cost of making precise decisions. Because firms are owned by risk-averse households, there are greater incentives to deliver profits when aggregate consumption is low. Thus, firms exert more cognitive effort and make smaller input-choice mistakes in aggregate downturns. In the data, consistent with our model, financial markets punish mistakes more in downturns and macroeconomically attentive firms make smaller mistakes. When calibrated to match our evidence, attention cycles generate quantitatively significant asymmetric, state-dependent shock propagation and stochastic volatility of output growth.
The second chapter, “Strategic Mistakes” (jointly authored with Joel P. Flynn), more abstractly studies the equilibrium implications of state-dependent imperfections in optimization. We introduce a model of costly control in continuum-player games in which agents interact via an aggregate of the actions of others. We find primitive conditions such that equilibria exist, are unique, are efficient, and feature monotone comparative statics for action distributions, aggregates, and the size of agents’ mistakes. We use our results to provide robust equilibrium predictions in a class of generalized beauty contests, which we apply to study the implications of imperfect optimization for financial speculation and price-setting.
The third chapter, “Managing Expectations: Instruments vs. Targets” (jointly authored with George-Marios Angeletos), studies how bounded rationality affects the optimal communication of policy commitments. Specifically, we study the question: should policy communications aim at anchoring expectations of the policy instrument (“keep interest rates at zero until date 𝑥”) or of the targeted outcome (“do whatever it takes to bring unemployment down to 𝑢%”)? People have limited depth of knowledge and rationality, and thus form beliefs about the behavior of others and the general equilibrium (GE) effects of policy that are distorted relative to the policymaker’s. We show that the bite of this distortion on implementability and welfare is minimized by target-based guidance if and only if GE feedback is strong enough. Our results rationalize why central banks should shine the spotlight on unemployment when faced with a prolonged liquidity trap, a steep Keynesian cross, or a large financial accelerator.
The final chapter, “Disagreement About Monetary Policy,” empirically and theoretically studies the causes and consequences of belief differences between markets and central banks about monetary policy over the business cycle. Using US data since 1995, I document that bad macroeconomic news in leading indicators predicts market over-estimation of interest rates and employment, relative to both the ex post realizations and the US Federal Reserve’s contemporaneous forecasts. In a model that accommodates disagreements between the market and central bank via three mechanisms—asymmetries in signals about fundamentals, beliefs about the monetary rule, and confidence in public signals—I show that different confidence in public signals is necessary to explain the empirical findings. The model implies that the market’s relative under-reaction to public signals substantially dampens the response of market beliefs to fundamentals, while central-bank signaling about fundamentals or the “information effect” has almost no role. |
| first_indexed | 2024-09-23T08:15:11Z |
| format | Thesis |
| id | mit-1721.1/144513 |
| institution | Massachusetts Institute of Technology |
| last_indexed | 2024-09-23T08:15:11Z |
| publishDate | 2022 |
| publisher | Massachusetts Institute of Technology |
| record_format | dspace |
| spelling | mit-1721.1/1445132022-08-30T04:05:56Z Bounded Rationality in Macroeconomics Sastry, Karthik Amrutur Angeletos, George-Marios Acemoglu, Daron Massachusetts Institute of Technology. Department of Economics People are inattentive, forgetful, and otherwise imperfect decisionmakers. It is well documented that models of choice with cognitive or attentional constraints, or bounded rationality, can capture these realities and explain deviations of individual behavior from a benchmark of pure payoff maximization. This thesis studies the aggregate implications of such imperfect reasoning and decision making for macroeconomic dynamics and policy. The first chapter, “Attention Cycles” (jointly authored with Joel P. Flynn), studies the causes and consequences of fluctuations in apparent bounded rationality over the business cycle. Using data from US public firms’ regulatory filings and financial statements, we document that firms’ attention to macroeconomic conditions rises in downturns and that their propensity to make input-choice mistakes rises in booms. We explain these phenomena with a business-cycle model in which firms face a cognitive cost of making precise decisions. Because firms are owned by risk-averse households, there are greater incentives to deliver profits when aggregate consumption is low. Thus, firms exert more cognitive effort and make smaller input-choice mistakes in aggregate downturns. In the data, consistent with our model, financial markets punish mistakes more in downturns and macroeconomically attentive firms make smaller mistakes. When calibrated to match our evidence, attention cycles generate quantitatively significant asymmetric, state-dependent shock propagation and stochastic volatility of output growth. The second chapter, “Strategic Mistakes” (jointly authored with Joel P. Flynn), more abstractly studies the equilibrium implications of state-dependent imperfections in optimization. We introduce a model of costly control in continuum-player games in which agents interact via an aggregate of the actions of others. We find primitive conditions such that equilibria exist, are unique, are efficient, and feature monotone comparative statics for action distributions, aggregates, and the size of agents’ mistakes. We use our results to provide robust equilibrium predictions in a class of generalized beauty contests, which we apply to study the implications of imperfect optimization for financial speculation and price-setting. The third chapter, “Managing Expectations: Instruments vs. Targets” (jointly authored with George-Marios Angeletos), studies how bounded rationality affects the optimal communication of policy commitments. Specifically, we study the question: should policy communications aim at anchoring expectations of the policy instrument (“keep interest rates at zero until date 𝑥”) or of the targeted outcome (“do whatever it takes to bring unemployment down to 𝑢%”)? People have limited depth of knowledge and rationality, and thus form beliefs about the behavior of others and the general equilibrium (GE) effects of policy that are distorted relative to the policymaker’s. We show that the bite of this distortion on implementability and welfare is minimized by target-based guidance if and only if GE feedback is strong enough. Our results rationalize why central banks should shine the spotlight on unemployment when faced with a prolonged liquidity trap, a steep Keynesian cross, or a large financial accelerator. The final chapter, “Disagreement About Monetary Policy,” empirically and theoretically studies the causes and consequences of belief differences between markets and central banks about monetary policy over the business cycle. Using US data since 1995, I document that bad macroeconomic news in leading indicators predicts market over-estimation of interest rates and employment, relative to both the ex post realizations and the US Federal Reserve’s contemporaneous forecasts. In a model that accommodates disagreements between the market and central bank via three mechanisms—asymmetries in signals about fundamentals, beliefs about the monetary rule, and confidence in public signals—I show that different confidence in public signals is necessary to explain the empirical findings. The model implies that the market’s relative under-reaction to public signals substantially dampens the response of market beliefs to fundamentals, while central-bank signaling about fundamentals or the “information effect” has almost no role. Ph.D. 2022-08-29T15:52:37Z 2022-08-29T15:52:37Z 2022-05 2022-06-06T12:48:48.955Z Thesis https://hdl.handle.net/1721.1/144513 In Copyright - Educational Use Permitted Copyright retained by author(s) https://rightsstatements.org/page/InC-EDU/1.0/ application/pdf Massachusetts Institute of Technology |
| spellingShingle | Sastry, Karthik Amrutur Bounded Rationality in Macroeconomics |
| title | Bounded Rationality in Macroeconomics |
| title_full | Bounded Rationality in Macroeconomics |
| title_fullStr | Bounded Rationality in Macroeconomics |
| title_full_unstemmed | Bounded Rationality in Macroeconomics |
| title_short | Bounded Rationality in Macroeconomics |
| title_sort | bounded rationality in macroeconomics |
| url | https://hdl.handle.net/1721.1/144513 |
| work_keys_str_mv | AT sastrykarthikamrutur boundedrationalityinmacroeconomics |