Should-Read: Paul De Grauwe and Yuemei Ji: Behavioural economics is also useful in macroeconomics

Should-Read: Paul De Grauwe and Yuemei Ji: Behavioural economics is also useful in macroeconomics: “Concepts from behavioural economics… [help] develop macroeconomic models with endogenous business cycle fluctuations…

…Application of the models highlights how the trade-off between output and inflation is moderated by the flexibility of the economy… [and] help to explain… international transmission…. Assuming that agents experience cognitive limitations… [and] use simple forecasting rules (heuristics) and evaluate the forecasting performances of these rules ex post. This evaluation leads them to switch to the rules that perform best…. This adaptive learning assumption… produces endogenous waves of optimism and pessimism (animal spirits) that drive the business cycle in a self-fulfilling way. This also leads to a two-way causality. That is, optimism (pessimism) leads to an increase (decline) in output, and the increase (decline) in output in term intensifies optimism (pessimism). An important feature of this dynamics of animal spirits is that the movements of the output gap are characterised by periods of tranquility alternating in an unpredictable way with periods of intense movements reflecting booms and busts…