NBER Reporter: Winter 2000/2001

Macroeconomics and Individual Decisionmaking

As part of the NBER's Project on Behavioral Macroeconomics, there was a meeting on "Macroeconomics and Individual Decisionmaking" in Cambridge on November 18. Project Directors George A. Akerlof, University of California, Berkeley, and Robert J. Shiller, NBER and Yale University, set the following agenda:

Xavier Gabaix, MIT, and David I. Laibson, NBER and Harvard University, "The 6D Bias and the Equity Premium Puzzle"

Discussant: Karen E. Dynan, Federal Reserve Board of Governors

George A. Akerlof, and William T. Dickens and George L. Perry, Brookings Institution, "Near-Rational Wage and Price Setting and the Long-Run Phillips Curve"

Discussant: Robert J. Shimer, NBER and Princeton University

Steven N. Durlauf, NBER and University of Wisconsin, "A Framework for the Study of Individual Behavior and Social Interactions"

Discussant: Russell W. Cooper, NBER and Boston University

Roland J. Benabou, NBER and Princeton University, and Jean Tirole, Université des Sciences Sociales, Toulouse, "Willpower and Personal Rules"

Discussant: Botond Koszegi, University of California, Berkeley

Sendhil Mullainathan, NBER and MIT, "Thinking through Categories: A Model of Cognition"

Discussant: Edward D. O'Donoghue, Cornell University

David E. Lebow, Raven E. Saks, and Beth Anne Wilson, Federal Reserve Board of Governors, "Downward Nominal Wage Rigidity: Evidence from the Employment Cost Index"

Discussant: Shulamit Kahn, Boston University

If decision costs lead agents to update consumption only every D periods, then high-frequency data will exhibit an unusually low correlation between equity returns and consumption growth. Gabaix and Laibson characterize the dynamic properties of an economy composed of consumers who delay updating in this way. Using a Mehra-Prescott procedure, an econometrician would infer a coefficient of relative risk aversion biased upward by a factor of 6D. With quarterly data, if agents adjust their consumption every D = 4 quarters, the imputed coefficient of relative risk aversion will be 24 times greater than the true value. High levels of risk aversion implied by the equity premium and violations of the Hansen-Jaganathan bounds cease to be puzzles. The neoclassical model with delayed adjustment explains the consumption behavior of shareholders. Once limited participation is taken into account, the model matches the high-frequency properties of aggregate consumption and equity returns.

In their paper, Akerlof, Dickens, and Perry question the basic assumptions about how expectations of inflation are used. From evidence about how people actually use information in making decisions, they develop an alternative to the natural-rate model based on more realistic, near rational behavior. They find that rather than having a unique natural rate, the economy exhibits a range of sustainable unemployment rates consistent with low rates of inflation. The lowest sustainable unemployment rate is well below the natural rate as usually estimated and is associated with inflation rates moderately above zero.

Recent work in economics has begun to integrate sociological ideas into the modeling of individual behavior. In particular, this new approach emphasizes how social context and social interdependency influence the ways in which individuals make choices. Durlauf provides an overview of an approach to integrating the theoretical and empirical analysis of such environments. His analysis is based on a framework in Brock and Durlauf (2000a and 2000b). In this paper, he assesses empirical evidence on behalf of this perspective and explores some of its policy implications.

Benabou and Tirole study internal commitment mechanisms or "personal rules" (diets, exercise regimens, resolutions, moral or religious precepts, and so on) through which people attempt to achieve self-discipline. The basic idea, which builds on Ainslie (1992), is that rules cause lapses to be interpreted as precedents, resulting in a loss of self-reputation that has an adverse impact on future self-control. The authors model the behavior of individuals who are unsure of their willpower, and they characterize rules as self-reputational equilibriums in which impulses are held in check by the fear of "losing faith in oneself." They then examine how equilibrium conduct is affected by opportunistic distortions of memory or inference, such as finding excuses for one's past behavior. The authors show that excessively rigid rules--anorexia, workaholism--can be understood as costly forms of self-signaling. In equilibrium, individuals are so afraid of appearing weak to themselves that every decision becomes a test of their willpower, even when the stakes are minor or when self-restraint is not desirable. The authors' results show that "salience of the future" is not only consistent with, but actually generated by, present-oriented preferences.

Mullainathan presents a model in which people use categories to think about the world around them. Faced with data, they first pick a category that best matches it. To make predictions, they ask how representative an outcome would be of the chosen category. This simple model unifies many of the experimentally documented biases: the law of small numbers, the hot hand, representativeness, and the conjunction fallacy. Moreover, the model provides enough structure that it results in readily testable out-of-sample predictions regarding these biases.

Lebow, Saks, and Wilson examine the extent of downward nominal wage rigidity using the microdata underlying the Bureau of Labor Statistics's employment cost index. This dataset has two significant advantages over those used previously. It is extensive, nationally representative, and based on establishment records. Thus it is free from much of the reporting error that has plagued work using the Panel Study of Income Dynamics and Current Population Survey. It also contains detailed information on benefit costs, allowing a first look at the rigidity of total compensation -- arguably the more relevant measure from the firm's perspective. In general, the authors find significantly stronger evidence of downward nominal wage rigidity than did studies using panel data on individuals. Total compensation appears somewhat more flexible than wages and salaries. However, this increased flexibility does not seem to reflect the deliberate attempt by firms to use benefits to circumvent wage and salary rigidity.

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