We introduce behavioral learning equilibria (BLE) into a multi-variate linear framework and apply it to New Keynesian DSGE models. In a BLE, boundedly rational agents use simple but optimal first-order autoregressive (AR(1)) forecasting rules whose parameters are consistent with the observed sample mean and autocorrelation of past data. We study the BLE concept in a standard three-equation New Keynesian model and develop an estimation methodology for the canonical Smets and Wouters (2007) model. A horse race between rational expectations equilibrium (REE), BLE and constant gain learning models shows that the BLE model outperforms the REE benchmark and is competitive with constant gain learning models in terms of in-sample and out-of-sample fitness. Sample autocorrelation learning of optimal AR(1) beliefs provides the best fit when short-term survey data on inflation expectations are considered in the estimation. As a policy application, we show that optimal Taylor rules under AR(1) expectations inherit history dependence, requiring a lower degree of interest rate smoothing than REE.

This paper presents a framework for analyzing how bounded rationality affects monetary and fiscal policy. The model is a tractable and parsimonious enrichment of the widely-used New Keynesian model – with one main new parameter, which quantifies how poorly agents understand future policy and its impact. That myopia parameter, in turn, affects the power of monetary and fiscal policy in a microfounded general equilibrium. A number of consequences emerge. (i) Fiscal stimulus or \helicopter drops of money" are powerful and, indeed, pull the economy out of the zero lower bound. More generally, the model allows for the joint analysis of optimal monetary and fiscal policy. (ii) The Taylor principle is strongly modified: even with passive monetary policy, equilibrium is determinate, whereas the traditional rational model yields multiple equilibria, which reduce its predictive power, and generates indeterminate economies at the zero lower bound (ZLB). (iii) The ZLB is much less costly than in the traditional model. (iv) The model helps solve the “forward guidance puzzle”: the fact that in the rational model, shocks to very distant rates have a very powerful impact on today's consumption and inflation: because agents are partially myopic, this effect is muted. (v) Optimal policy changes qualitatively: the optimal commitment policy with rational agents demands “nominal GDP targeting”; this is not the case with behavioral firms, as the benefits of commitment are less strong with myopic forms. (vi) The model is “neo-Fisherian” in the long run, but Keynesian in the short run: a permanent rise in the interest rate decreases inflation in the short run but increases it in the long run. The non-standard behavioral features of the model seem warranted by the empirical evidence.

In mainstream economics, and particularly in New Keynesian macroeconomics, the booms and busts that characterize capitalism arise because of large external shocks. The combination of these shocks and the slow adjustments of wages and prices by rational agents leads to cyclical movements. In this book, Paul De Grauwe argues for a different macroeconomics model--one that works with an internal explanation of the business cycle and factors in agents' limited cognitive abilities. By creating a behavioral model that is not dependent on the prevailing concept of rationality, De Grauwe is better able to explain the fluctuations of economic activity that are an endemic feature of market economies. This new approach illustrates a richer macroeconomic dynamic that provides for a better understanding of fluctuations in output and inflation. De Grauwe shows that the behavioral model is driven by self-fulfilling waves of optimism and pessimism, or animal spirits. Booms and busts in economic activity are therefore natural outcomes of a behavioral model. The author uses this to analyze central issues in monetary policies, such as output stabilization, before extending his investigation into asset markets and more sophisticated forecasting rules. He also examines how well the theoretical predictions of the behavioral model perform when confronted with empirical data. Develops a behavioral macroeconomic model that assumes agents have limited cognitive abilities Shows how booms and busts are characteristic of market economies Explores the larger role of the central bank in the behavioral model Examines the destabilizing aspects of asset markets

This paper provides a bird's eye view of the Behavioural New Keynesian literature. We discuss three key empirical regularities in macroeconomic data which are not accounted for by the standard New Keynesian model, namely, excess kurtosis, stochastic volatility, and departures from rational expectations. We then present a simple Behavioural New Keynesian model that accounts for these empirical regularities in a straightforward manner. We discuss elaborations and extensions of the basic model, and suggest areas for future research.

We develop a New Keynesian model with household heterogeneity and bounded rationality in the form of cognitive discounting. The interaction of household heterogeneity and bounded rationality generates amplification of monetary and fiscal policy through indirect general equilibrium effects while simultaneously ruling out the forward guidance puzzle and remaining stable at the effective lower bound. Thus, the model can account for recent empirical findings on the transmission mechanisms and effectiveness of monetary and fiscal policy. When abstracting from either household heterogeneity or bounded rationality the model fails to do so. Our framework nests a broad range of existing models, none of which can be consistent with all these empirical facts simultaneously. According to our model, central banks have to increase interest rates more strongly than in the rational model after an inflationary supply shock to fully stabilize inflation. While fully stabilizing inflation keeps output at potential, higher real interest rates mainly benefit wealthy households and increase the cost of government debt, leading to a substantial increase in government debt and inequality. Our model thus indicates a more pronounced trade off between aggregate efficiency and price stability on one hand, and distributional consequences and fiscal sustainability on the other hand.