BE HAVI ORAL MACR OEC ON O MICS AND MACR OEC ON O MIC BE HAVI OR

Prize Lecture, Dece mber 8, 2001 by

G E OR GE A. A KERL OF * Depart me nt of Eco no mics, U niversity of Califor nia, Berkeley, C A 94720-3880, U S A.

Think about Richard Scarry’s Cars and Trucks and Things That Go. 1 T hi n k abo ut w hat t hat book wo ul d have looke d like i n seq ue ntial deca des of t he last ce ntury had Ric hard Scarry bee n alive i n eac h of t he m to delig ht a nd a muse children and parents. Each subsequent decade has seen the develop ment of ever more specialized vehicles. We started with the model- T Ford. We no w have more models of backhoe loaders than even the most precocious four- y e ar ol d c a n i d e ntify. W hat releva nce does t his have for eco no mics? I n t he late 1960s t here was a s hift i n t he job descri ptio n of eco no mic t heorists. Prior to t hat ti me micro- econo mic theory was mainly concerned with analyzing the purely co mpetiti- ve, general equilibriu m model based upon profit maxi mization by fir ms and utility maxi mizatio n by co nsu mers. T he macroeco no mics of t he day, t he so- called neoclassical sy nt hesis, appe nded a fixed mo ney wage to suc h a ge neral equilibriu m syste m. “Sticky money wages” explained departures fro m full e mploy me nt a nd busi ness cycle fluctuatio ns. Si nce t hat ti me, bot h micro a nd macroeco no mics have developed a Scarry-ful book of models desig ned to i n- cor porate i nto eco no mic t heory a w hole variety of realistic be haviors. For ex- a mple, “ The Market for ‘ Le mons’” explored ho w markets with asy m metric in- for mation operate. Buyers and sellers co m monly possess different, not identical infor mation. My paper exa mined the pathologies that may develop u n der t hese more realistic co n ditio ns. For me, t he st u dy of asy m metric i nfor matio n was a very first ste p to war d t he realization of a drea m. That drea m was the develop ment of a behavioral macroecono mics in the original spirit of Keynes’ Ge neral Theory. M a cr o- eco no mics would t he n no lo nger suffer fro m t he a d hockery of t he ne oclassical sy nt hesis, w hic h had over-ridde n t he e mp hasis i n The Ge neral Theory o n t he r ole of psyc h ol ogical a n d s oci ol ogical fact ors, s uc h as c og nitive bias, reci pr o-

* T he a ut hor wo ul d like to t ha nk Ja net Yelle n for extraor di narily hel pf ul disc ussio ns a n d e dito- rial assista nce. He would also like to t ha nk He nry Aaro n, Willia m Dicke ns, Er nst Fe hr, Willia m Gale, and Robert Shiller for invaluable co m ments and the Canadian Institute for Advanced Researc h for ge nerous fi na ncial support. 1 See Ric har d Scarry (1974).

3 6 5 city, fair ness, her di ng, a n d social stat us. My drea m was to stre ngt he n macro- e c o n o mi c t h e or y by i n c or p or ati n g ass u m pti o ns h o n e d t o t h e o bs er v ati o n of suc h be havior. A tea m of people have participated i n t he realizatio n of t his drea m. Kurt Vo n negut would call t his tea m a ker ass, “a group of people who are unkno wingly working together to ward so me co m mon goal fostered by a larger cos mic in fluence.” 2 I n t his lect ure I s hall describe so me of t he be ha- vioral models developed by t his ker ass to provide plausible expla natio ns for macroecono mic pheno mena that are central to Keynesian econo mics. For t he sake of backgrou nd, let me take you back a bit i n ti me to revie w so me history of macroeco no mic t houg ht. I n t he late 1960s t he Ne w Classical econo mists sa w the sa me weaknesses in the microfoundations of macroeco- no mics t hat have motivate d me. T hey hate d its lack of rigor. A n d t hey sacke d it. They then held a celebratory bonfire, with an article entitled “ After Keynesian Macroecono mics.” 3 The ne w version of macroecono mics that they produced beca me sta ndard i n t he 1970s. Follo wi ng its neoclassical sy nt hesis predecessor, Ne w Classical macroecono mics was based on the co mpetitive, g e n er al e q uili bri u m m o d el. B ut it diff er e d i n b ei n g m u c h m or e z e al o us i n i n- sisti ng t hat all decisio ns – co ns u m ptio n a n d labor s u p ply by ho use hol ds, o ut- put, e mploy me nt a nd prici ng decisio ns by producers, a nd t he wage bargai ns bet ween both workers and fir ms – be consistent with maxi mizing behavior. 4 Ne w Classical macroecono mics therefore gave up the assu mption of sticky money wages. To account for une mploy ment and econo mic fluctuations, Ne w Classical eco no mists relied first o n i mperfect i nfor matio n a nd later o n tec h nology s hocks. T he ne w t heory was a step for ward i n at least o ne respect: price a nd wage decisio ns were no w based upo n explicit microfou ndatio ns. But t he be havioral assu mptio ns were so pri mitive t hat t he model faced extre me dif ficulty i n ac- counting for at least six macroecono mic pheno mena. In so me cases, logical i nco nsiste ncy wit h key ass u m ptio ns of t he ne w classical mo del le d to o utrig ht de nials of t he p he no me na i n q uestio n; i n ot her cases, t he ex pla natio ns offer- ed were merely tortuous. The six pheno mena are: – The existence of involuntary une mploy ment : In the ne w classical model, an u ne mployed worker ca n easily obtai n a job by offeri ng to work for just a s midgeo n less t ha n t he market-cleari ng salary or wage; so i nvolu ntary u n- e mploy ment cannot exist. – T he i m p act of mo net ary policy o n o ut p ut a n d e m ploy me nt : I n t h e n e w cl assi c al m o- del, mo netary policy is all but i neffective i n c ha ngi ng output a nd e mploy- me nt. O nce c ha nges i n t he mo ney supply are fully foresee n, prices a nd wa-

2 See http:// w w w.gibbsonline.co m/gibbsbooks.ht ml. 3 See Lucas a nd Sarge nt (1979). 4 Most of t hese p uzzles were dor ma nt at t he ti me; t hey were i n here nt i n t he literat ure, b ut t here was no active discussio n of t he m. Probably t he most active researc h progra m i n macroeco no mics during the late1960s was the develop ment of large scale macroecono metric models. The models of search une mploy ment by Phelps et al (1970) appeared i n t he late 1960s to a ns wer t he ques- tion: what is the meaning of une mploy ment? But they adopted a fra me work of search une mploy- me nt, w hic h was, by nat ure, vol u ntary.

3 6 6 ges c ha nge pro portio nately; real wages a n d relative prices are co nsta nt; a n d t here is no i mpact o n t he real eco no my w hatsoever. – The failure of de flation to accelerate when une mploy ment is high : The New Classical mo del pro d uces a n acceleratio nist P hilli ps C urve wit h a u niq ue na- tural rate of u ne mploy me nt. If u ne mploy me nt falls belo w t his natural rate, i n flatio n accelerates. Wit h u ne mploy me nt above t he natural rate, i n flatio n c o nti n ually decelerates. – The prevale nce of u ndersavi ng for retire me nt : I n t h e N e w Cl assi c al m o d el i n divi- duals decide ho w much to consu me and to save to maxi mize an interte m- poral utility f u nctio n. T he co nseq ue nce is t hat privately deter mi ne d savi ng s hould be just about opti mal. But i ndividuals co m mo nly report disappoi nt- me nt wit h t heir savi ng be havior a n d, abse nt social i ns ura nce progra ms, it is widely believed that most people would undersave. “Forced saving” pro- gra ms are extre mely po p ular. – T he e xcessi ve vol atility of stoc k prices rel ati ve to t heir f u n d a me nt als : N e w Cl assi c al t heory assu mes t hat stock prices re flect fu nda me ntals, t he discou nted value of f ut ure i nco me strea ms. – T he st ubbor n persiste nce of a self- destr uctive u n dercl ass: My list of macroeco no mic q uestio ns to be ex plai ne d i ncl u des t he reaso ns for poverty beca use I vie w i n- co me distributio n as a topic i n macroeco no mics. Neoclassical t heory sug- gests t hat poverty is t he re flectio n of lo w i nitial e ndo w me nts of hu ma n a nd nonhu man capital. The theory cannot account for persistent and extre me poverty coupled wit h hig h i ncide nce of drug a nd alco hol abuse, out-of- wed- lock births, single-headed households, high welfare dependency, and cri m e. 5 I n w hat follo ws I s hall describe ho w be havioral macroeco no mists, i ncorpo- rati ng realistic assu mptio ns grou nded i n psyc hological a nd sociological ob- servatio n, have produced models t hat co mfortably accou nt for eac h of t hese macroecono mic pheno mena. In the spirit of Keynes’ Ge neral Theory , b e h avi o- ral macroecono mists are rebuilding the microfoundations that were sacked

5 I have left out t wo i mporta nt questio ns w hose microfou ndatio ns have bee n developed si nce t he late 1960s. First, w hy mig ht credit be ratio ned? Do nald Hodg ma n (1960, p. 258) makes clear t hat the econo mic theory of the early 1960s found credit rationing to be an unexplained puzzle: “ Eco no mists of a more a nalytical persuasio n have bee n relucta nt to accept [credit ratio ni ng] at face value because of t heir dif ficulty i n providi ng a t heoretical expla natio n for t he p he no me no n w hic h is co nsiste nt wit h t he te nets of ratio nal eco no mic be havior. W hy s ho ul d le n ders allocate by no n-price mea ns a nd t hus de ny t he mselves t he adva ntage of hig her i nterest i nco me?” He attri- butes suc h vie ws to Paul Sa muelso n as revealed i n Co ngressio nal testi mo ny. Asy m metric i nfor- matio n provides a n excelle nt reaso n for credit ratio ni ng. (See especially Jaffee a nd Russell (1976) a nd Stiglitz a nd Weiss (1981)). A seco nd questio n relati ng to microfou ndatio ns co ncer ns t he reaso ns for leads a nd lags i n macroeco no mic variables, suc h as durable co nsu mptio n, mo ney de ma nd, a nd prices. S-s models wit h lu mpy costs to maki ng c ha nges ca n explai n suc h leads a nd lags ( u nless t he variable i n q uestio n is eit her al ways decreasi ng or al ways i ncreasi ng). Pio neeri ng work o n t he effects of S-s prici ng has bee n do ne especially by I wai (1981) a nd Barro (1972). Caballero (see, for exa m ple, 1993) has co m pare d t he lea ds a n d lags i n s uc h mo dels wit h a sit ua- tion with no costs of adjust ment. Caplin and Spulber (1987) and Caplin and Leahy (1991) have als o l o o k e d at t h e i m pli c ati o ns of S-s p oli cy f or t h e r el ati o n b et w e e n t h e s hifts i n t h e i d e al pri c e a n d t he act ual price bei ng c harge d. See Akerlof (1973, 1979) for a nalysis of t he effects of target- t hres hold mo nitori ng o n t he s hort-ru n i nco me a nd i nterest elasticity of t he de ma nd for mo ney.

3 6 7 by t he Ne w Classical eco no mics. I s hall begi n my revie w by describi ng o ne of my earliest atte m pts i n t his fiel d, w hic h le d to t he discovery of t he role of asy m metric i nfor matio n i n markets.

ASY M METRIC INF OR MATI ON I first ca me upon the proble ms resulting fro m asy m metric infor mation in an e arly i nv esti g ati o n of a l e a di n g c a us e f or fl u ct u ati o ns i n o ut p ut a n d e m pl oy- me nt – large variati o ns i n t he sales of ne w cars. 6 I t h o u g ht t h at illi q ui dity, d u e to t he fact t hat sellers of use d cars k no w more t ha n t he b uyers of use d cars, mig ht ex plai n t he hig h volatility of a uto mobile p urc hases. 7 I n tryi ng to make suc h a macroeco no mic model, I got diverted. I discovered t hat t he i nfor ma- tio nal proble ms t hat exist i n t he use d car market were pote ntially prese nt to so me degree i n all markets. I n so me markets, asy m metric i nfor matio n is fair- ly easily s ol u ble by re peat sale a n d by re p utati o n. I n ot her markets, s uc h as i n- sura nce markets, credit markets, a nd t he market for labor, asy m metric i nfor- matio n bet wee n b uyers a n d sellers is not easily sol uble a n d res ults i n serio us market breakdo w ns. For exa mple, t he elderly have a hard ti me getti ng healt h i ns ura nce; s mall b usi nesses are likely to be cre dit-ratio ne d; a n d mi norities are likely to experie nce statistical discri mi natio n i n t he labor market because people are lu mped toget her i nto categories of t hose wit h si milar observable traits. T he failure of credit markets is o ne of t he major reaso ns for u nder- develop ment. Even where mechanis ms such as reputation and repeat sales arise to overco me t he proble m of asy m metric i nfor matio n, suc h i nstitutio ns beco me a major deter mi na nt of market structure. To u ndersta nd t he origi ns of t he eco no mics of asy m metric i nfor matio n i n markets, it is usef ul t o re flect o n t he m ore ge neral i ntellect ual rev ol uti o n t hat was occ urri ng at t he ti me. Prior to t he early 1960s, eco no mic t heorists rarely constructed models custo mized to capture unique institutions or specific market characteristics. Cha mberlin’s monopolistic co mpetition and Joan Robi nso n’s equivale nt 8 were taug ht i n graduate a nd eve n a fe w u ndergradua- te co urses; b ut s uc h “s peci fic” mo dels were t he rare exce ptio n; t hey were pre- se nte d n ot as ce ntral sig hts, b ut i nstea d as exc ursi o ns i nt o t he c o u ntrysi de, f or t he a dve nt uro us or t hose wit h a n extra day to s pare. 9 D uri ng t he early 1960s, ho wever, “special” models bega n to proliferate as gro wt h t heorists, worki ng slig htly outside t he nor ms of sta ndard price-t heoretic eco no mics, bega n to co nstr uct mo dels wit h s pecialize d tec h nological feat ures: p utty-clay, vi ntage capital a nd lear ni ng by doi ng. T he i ncorporatio n i nto models of suc h specia- lize d tec h nologies violate d no establis he d price-t heoretic nor m, b ut it so we d

6 See Akerlof (1970). 7 Mis hki n (1976) later develo pe d t he i deas t hat set me o n t his co urse i nitially. He s ho we d w hy t he de ma nd for auto mobiles is more volatile because cars are illiquid due to asy m metric i nfor ma- ti o n. 8 See Cha mberlin (1962), and Robinson (1942). 9 For exa mple, I could well i magine a graduate student being una ware of Hotelling’s (1929) model of spatial co mpetition. I cannot re me mber it in the graduate curriculu m and re me mber fi ndi ng it tucked a way as a n appe ndix to C ha mberli n’s Mo no polistic Co m petitio n.

3 6 8 t he seed for t he revolutio n t hat was to co me. Duri ng t he su m mer of 1969, I first hear d t he w or d mo del us e d as a v er b, a n d n ot j ust as a n o u n. 1 0 It is n o c oi n- cidence that just a fe w months earlier “ The Market for ‘ Le mons’” had been acce pte d for p ublicatio n. 1 1 T h e ‘ m o d eli n g’ of asy m m etri c i nf or m ati o n i n m ar- kets was t o price t he ory w hat t he ‘ m o deli ng’ of p utty-clay, vi ntage ca pital, a n d lear ni ng by doi ng had bee n to gro wt h t heory. 1 2 It was t he first a p plicati o n of a ne w eco no mic orie ntatio n i n w hic h models are co nstructed wit h careful at- te ntio n to realistic microeco no mic detail. T his develop me nt has broug ht eco- no mic t heory m uc h closer to t he fi ne grai n of eco no mic reality. Al most i nevi- tably, t he a nalysis of i nfor matio n asy m metries was t he first fr uit of t his ne w mo deli ng orie ntatio n. It was t he ri pest fr uit for picki ng. I n t he re mai n der of t his essay I s hall disc uss t he pay offs of t his ne w orie ntati o n f or t he ne w fiel d of behavioral macroecono mics.

INVOLUNTARY UNE MPLOY MENT I once had an econo mist friend who said that he co ul d not sell his h o use, a co m plai nt t hat I reiterate d sy m pat hetically to o ne of his colleag ues. T he col- league responded that there was only one proble m: the house was unreason- a bly pri c e d. At a l o w er pri c e t h e h o us e w o ul d s ell, p er h a ps i nst a ntly. Ne w Classical eco no mics vie ws i nvolu ntary u ne mploy me nt as a logical i m- possibility, like my frie n d’s i nability to sell his ho use. Co ul d not a n u ne m- ploye d worker obtai n a job if o nly s he were willi ng to re d uce her reservatio n wage? T he Ne w Classical a ns wer is yes: u ne mployed workers are t hose sear- ching for work (hence une mployed, rather than out of the labor force) but rejecti ng jobs t hat are available because t hey had expected better pay. T he u ne mployed may be u n happy t hat t hey ca n not sell t heir labor at t he wage or salary t hat t hey wo ul d i deally like, b ut exce pt for t hose affecte d by t he mi ni- mu m wage or union bargaining, they are voluntarily, not involuntarily, une mployed. Everyone can get a job at the market-clearing wage. In Ne w Classical t heory, perio ds of decli ni ng e m ploy me nt – b usi ness cycle do w nt ur ns – may be caused by a n u nexpected decli ne i n aggregate de ma nd, w hic h leaves workers mistakenly holding out for no minal wages that exceed the ne w market-cleari ng level. 1 3 Alternatively, declining e mploy ment may be due to negative supply s hocks, w hic h cause workers to wit hdra w fro m t he labor force and esche w the jobs that are available. Any account of the business cycle base d o n vol u ntary variatio ns i n job-taki ng faces a sig ni fica nt e m pirical dif-

1 0 Conversation with Michael Rothschild in Ca mbridge, Massachusetts, Su m mer of 1969. I re- me mber the usage just as many people today may re me mber the first ti me they heard so meone say t hey would “gro w t he eco no my.” 1 1 I d o n ot have t he exact date of t he acce pta nce of t his article, b ut I re me m ber t hat it t o ok slig ht- ly more t ha n a year bet wee n accepta nce a nd publicatio n. 1 2 See Solo w (1959, 1962) and Arro w (1962). 1 3 T his t heory s uffers fro m a f urt her t heoretical dif fic ulty. Si nce aggregate u ne m ploy me nt is rea d- ily observable wit h a s hort lag, workers s hould co nditio n t heir expectatio ns of prevaili ng wage distributions on the aggregate une mploy ment rate. Such conditioning would eli minate serial correlation in une mploy ment.

3 6 9 ficulty – to explain why quits decline in cyclical do wnturns. If higher une mploy ment results fro m workers’ rejection of the poor returns fro m work, quits s hould rise alo ng wit h u ne mploy me nt. But t here are fe wer quits, not more, w he n u ne mploy me nt rises. T he procyclic be havior of quits is i n- dis p ut a bl e. 1 4 I nstead of de nyi ng t he very existe nce of i nvolu ntary u ne mploy me nt, be ha- vioral macroecono mists have provided coherent explanations. Efficiency wage t heories, w hic h first appeared i n t he 1970s a nd 1980s, make t he co ncept of involuntary une mploy ment meaningful. 1 5 T hese m o dels p osit t hat, f or rea- sons such as morale, fairness, insider po wer, or asy m metric infor mation, e mployers have strong motives to pay workers more than the mini mu m ne- cessary t o attract t he m. 1 6 Suc h “ef ficie ncy wages” are above market-cleari ng, so that jobs are rationed and so me workers cannot obtain the m. These workers are i nvol u ntarily u ne m ploye d. I n t he next sectio n I will exte n d t his reaso ni ng to ex plai n w hy i nvol u ntary u ne m ploy me nt varies cyclically. T he pervasive e mpirical fi ndi ng of a wide spread of ear ni ngs for see mi ngly si milar workers is stro ngly s uggestive of t he near ubiq uity of ef ficie ncy wages. Lo ng before t he ef ficie ncy wage was a glea m i n t he eye of macroeco no mists, labor econo mists had docu mented wide dispersion in earnings across see- mi ngly si milar jobs a n d a mo ng workers wit h a p pare ntly i de ntical c haracteris- ti cs. 1 7 A nalysis of pa nel data i n dicates t hat w orkers of t he sa me q uality receive different wages depending upon their place of work. Moreover, data sho w t hat workers w ho s witc h i ndustries receive wage c ha nges t hat are correlated wit h t he res pective wage differe ntials bet wee n t he i n d ustries. 1 8 I n d ustries wit h hig her pay (co n ditio nal o n c haracteristics) also have lo wer q uit rates, s ugges- ti ng t hat pay differe nces are not si m ply co m pe nsati ng differe ntials d ue to dif- fere nt worki ng co nditio ns or be ne fits. 1 9 It t h us a p pears t hat t here are “goo d jobs” a n d “ba d jobs.” T he existe nce of good jobs a nd bad jobs makes t he co ncept of i nvolu ntary une mploy ment meaningful: une mployed workers are willing to accept, but ca n not obtai n, jobs i de ntical to t hose c urre ntly hel d by workers wit h i de ntical ability. At t he sa me ti me, i nvolu ntarily u ne mployed workers may esc he w t he

1 4 T his questio n was raised by Tobi n (1972). For so me data o n t he cou ntercyclical be havior of quits, see Akerlof, Rose a nd Yelle n (1988). Ke n net h Mc Laug hli n (1991) has atte mpted to reco n- cile t he procyclicality of quits wit h Ne w Classical eco no mics as follo ws: He de fi nes quits as e mployee i nitiated separatio ns, a nd layoffs as fir m i nduced separatio ns. I n Mc Laug hli n’s model a positive pro d uctivity s hock ca uses more workers to ask for wage i ncreases. Si nce so me req uests are rejected, quits rise as u ne mploy me nt decli nes. But w hy s hould fir ms’ wage offers lag be hi nd worker de ma n ds i n t he face of a positive pro d uctivity s hock? 1 5 A n excelle nt co ncise s u m mary of t his literat ure is give n by Yelle n (1984). 1 6 T he i ncl usio n here of i nsi der-o utsi der mo dels is taki ng a n es pecially broa d i nter pretatio n of t he co nce pt of ef ficie ncy wages. 1 7 See Dunlop (1957). 1 8 See Dicke ns a nd Katz (1987) a nd Krueger a nd Su m mers (1988). Note t hat t hese studies are for t h e U nit e d St at es i n a p eri o d w h e n u ni o niz ati o n w as q uit e w e a k; it is t h us u nli k ely t o b e t h e m a- jor factor i n suc h wage differe ntials. I n co ntrast, Du nlop’s wage differe ntials, may have bee n m ai nly t h e r es ult of diff er e nti als i n u ni o n p o w er. 1 9 See Krueger and Su m mers (1988).

3 7 0 lo wer- payi ng or lo wer-skille d jobs t hat are available. T he de fi nitio n of i nvo- luntary une mploy ment i mplicit in efficiency wage theory accords with the facts and agrees with co m monly held perceptions. A meaningful concept of i nvolu ntary u ne mploy me nt co nstitutes a n i mporta nt first step for ward i n re- buildi ng t he fou ndatio ns of Key nesia n eco no mics. But why do fir ms pay wages above rock botto m? In my vie w, psychological a nd sociological expla natio ns for ef ficie ncy wages are e mpirically most co n- vi n ci n g. 2 0 Three i mportant considerations are: reciprocity (gift exchange t heory fro m a nt hropology), fair ness (equity t heory fro m psyc hology) a nd ad- here nce to group nor ms (refere nce group t heory i n sociology a nd t heory of gro u p for matio n i n psyc hology). I n t he earliest “sociological” versio n of ef fi- cie ncy wage t heory based o n gift exc ha nge, fir ms give workers above market- clearing wages and workers reciprocate in their co m mit ment to the fir m. 2 1 T he pay me nt of above- market-cleari ng wages may also be motivated by co nsi- deratio ns of fair ness: i n accor da nce wit h t he psyc hological t heory of eq uity, w orkers may exert less eff ort i ns ofar as t heir wage falls s h ort of w hat is c o nsi- d er e d f air. 2 2 Group nor ms typically deter mine the conceptions workers for m about ho w gifts s hould be reciprocated a nd w hat co nstitutes a fair wage. I n t he laboratory, Fe hr a nd his co-aut hors have establis hed t he i mporta nce bot h of reci procal be havior a n d social nor ms for worker effort i n ex peri me ntal set- ti n gs. 2 3 My favorite versio n of ef ficie ncy wages is t he i nsi der-o utsi der mo del, w hereby i nsider workers preve nt t he fir m fro m hiri ng outsiders at a market cleari ng wage lo wer t ha n w hat t he i nsiders are curre ntly receivi ng. 2 4 T his t heory i m plicitly ass u mes t hat i nsi ders have t he ability to sabotage t he i ncl u- si o n of n e w w or k ers i nt o a fir m. A d et ail e d st u dy by D o n al d R oy of a n Illi n ois mac hi ne s hop reveals t he dy na mics by w hic h t his may occur: I n Roy’s mac hi- ne s hop, i nsiders establis hed group nor ms co ncer ni ng effort a nd colluded to prevent the hiring of rate-busting outside workers. Workers who produced more t ha n t he level of output co nsidered “fair” were ostracized by ot hers. 2 5 Coll usio n by i nsi ders agai nst o utsi ders is a co m pelli ng motive for ma ny fir ms to pay wages t hat are above market cleari ng. A n alter native versio n of ef ficie ncy wage t heory, grou nded i n asy m metric i nfor matio n, vie ws above- market cleari ng wages as a discipli nary device. I n t he S hapiro-Stiglitz model, fir ms pay “ hig h” wages to reduce t he i nce ntive of workers to s hirk. T he atte m pt of all fir ms to pay “above average” wages, ho w- ever, pushes the average level of wages above market-clearing, creating une mploy ment. Une mploy ment serves as a disciplinary device, because wor-

2 0 See Katz (1986) a nd Bli nder a nd C hoi (1990). Bli nder a nd C hoi fi nd stro ng evide nce i n favor of morale co nsideratio ns for payi ng hig h wages as well as mixed evide nce i n favor of ef ficie ncy wages as a worker discipli ne device. Be wley (2000) co ncludes t hat morale is a n i mporta nt reaso n for failure to make wage cuts. Ca mpbell a nd Ka mla ni (1997) report t hat morale is a major reaso n fir ms do not make mo ney wage cuts, but so is co ncer n over quits by t he best workers. 2 1 See Akerlof (1982) a nd Rabi n (1993). 2 2 See Akerlof a nd Yelle n (1990) a nd Levi ne (1992). 2 3 See, for exa mple, Fe hr, Kirc hsteiger a nd Reidl (1993), Fe hr a nd Falk (1999) a nd Fe hr, Gac hter a n d Kirc hsteiger (1996). 2 4 See Lindbeck and Sno wer (1988). 2 5 See Roy (1952).

3 7 1 kers who are caught shirking and fired for lack of effort can beco me re- e mployed only after a period of une mploy ment. 2 6 The worker discipline model fits the standard logic of econo mics more co mfortably than approaches grounded in sociology and psychology. But so- ciological a nd psyc hological models, i ncludi ng t he i nsider-outsider model, that rely on ele ments outside the standard econo mic box, probably yield a better over-all expla natio n for i nvolu ntary u ne mploy me nt. T hese be havioral m o dels ca pt ure Key nes’ e m p hasis, i n t he i nitial c ha pters of t he Ge neral Theory, o n equity a nd relative wage co mpariso ns.

EFFECTIVE NESS OF M O NETARY P OLICY A ce ntral pro positio n of t he Ne w Classical Eco no mics is t hat mo netary policy, as lo ng as it is f ully perceive d, ca n have no effect o n o ut p ut or e m ploy me nt. Perfectly foresee n c ha nges i n t he mo ney supply i nduce ratio nal wage a nd price setters to raise or lo wer no mi nal wages a n d prices i n t he i de ntical pro portio n, leaving output and e mploy ment constant. 2 7 T his Ne w Classical hypot hesis co n flicts, ho wever, wit h e mpirical evide nce o n t he i mpact of mo netary policy a n d t he wi des prea d po p ular belief i n t he po wer of ce ntral ba nks to affect eco- no mic perfor mance. A major contribution of behavioral macroecono mics is to de monstrate t hat, u nder se nsible be havioral assu mptio ns, mo netary policy does aff ect r eal outco mes just as Keynesian econo mics long asserted. Cognitive psychology pict ures decisio n- makers as “i nt uitive scie ntists” w ho s u m marize i nfor matio n and make choices based on si mplified mental fra mes. 2 8 Relia nce o n r ules of t hu mb t hat o mit factors w hose co nsideratio n have o nly a s mall effect o n pro- fit or utility is a n i m plicatio n of s uc h cog nitive parsi mo ny. I n t he wage- price co ntext, si mple rules cause i nertia i n t he respo nse of aggregate wages (a nd prices) to s hocks – t he exact “sticky wage / price” be havior t hat Ne w Classical eco no mists ha d so scor nf ully deri de d. I n t he Ne w Classical critiq ue, t he i ner- tial wage be havior hy pot hesize d i n t he “ neoclassical sy nt hesis” is irratio nal, costly for workers a nd fir ms, he nce i mplausible. Be havioral eco no mists have responded by de monstrating that rules of thu mb involving “ money illusion”

2 6 See Shapiro and Stiglitz (1985) and also Bo wles (1985), Foster and Wan (1984) and Stoft (1982). T he worker- disci pli ne mo del ca pt ures a slice of reality, b ut, as t he w hole ex pla natio n for involuntary une mploy ment, it suffers fro m both theoretical and e mpirical difficulties. T heoretically, i n jobs w here s u pervisio n is i m perfect a n d workers ca n deter mi ne t heir o w n effort, fir ms with good reputations could de mand that workers post bonds. These bonds would be for- feite d i n t he eve nt t hat a worker is ca ug ht s hirki ng. As lo ng as t hey re mai n e m ploye d by t he fir m, workers would receive wages aug me nted by t he i nterest o n t he bo nd; t he pri ncipal would be re- turned at retire ment. This pay ment sche me solves the incentive proble m facing the fir m and is cheaper for the fir m than above, market-clearing efficiency wages. Becker and Stigler (1974) make t his precise suggestio n. I n t heir sc he me t he worker receives t he bo nd back w he n he leaves t h e j o b i n g o o d st a n di n g. ( Ot h er w ays t o r e d u c e w a g es t o m ar k et- cl e ari n g i n si mil ar s pirit h av e bee n poi nted out by Car mic hael (1985) a nd Murp hy a nd Topel (1990).) E mpirically, t he discip- li ne- device t heory fails to ex plai n w hy i n d ustry wage differe ntials are so hig hly correlate d across occupatio ns, so t hat so me i ndustries offer “good jobs” to workers i n all occupatio ns, i ncludi ng t hose w here t here is little sco pe to s hirk. (See Dicke ns a n d Katz (1987).) 2 7 T his l o gi c is cl e arly s p ell e d o ut by P ati n ki n ( 1 9 5 6 ).

3 7 2 are not o nly co m mo nplace but also se nsible – neit her fool hardy nor i mplau- si bl e: t h e l oss es fr o m r eli a n c e o n s u c h r ul es ar e e xtr e m ely s m all. 2 8 I n joi nt work wit h Ja net Yelle n, I first de mo nstrate d t his res ult i n t he co n- text of a model with efficiency wages and monopolistic co mpetition. We as- s u me d t hat so me price setters follo w t he r ule of t h u mb of kee pi ng prices co n- sta nt follo wi ng a s hock to de ma nd (caused by a c ha nge i n t he mo ney supply.) We s ho wed t hat t he losses to t he “rule-of-t hu mb” fir ms fro m t heir failure to readjust prices follo wi ng a c ha nge i n t he mo ney supply are seco nd-order ( or s m all), 2 9 w hereas t he i mpact o n output of a mo netary s hock i n t his eco no my is first-or der ( or si g ni fic a nt ) relative to t he size of t he s hock. 3 0 We dubbed the r ule-of-t h u mb strategies e m ploye d by fir ms wit h i nertial price-setti ng “ near-ra- tio nal” si nce t he losses t hey s uffer fro m t heir de part ure fro m co m plete o pti- miz ati o n ar e seco nd-order ( or s m all . ) T he l ogic of t he key res ult – t hat near-rati o nal price sticki ness is s uf ficie nt to i mpart sig ni fica nt po wer to mo netary policy – is si mple. Wit h mo nopolistic co mpetitio n, eac h fir m’s pro fit fu nctio n is seco nd-differe ntiable i n its o w n price so t hat t he pro fit fu nctio n is flat i n t he neig hborhood of t he opti mu m o wn-price. In consequence, any deviation fro m the profit- maxi mizing price ca uses a l oss i n pr o fits t hat is s mall – sec o n d- or der wit h res pect t o t he size of t hose deviatio ns. But if t he deviatio ns fro m t he opti mu m of a large nu mber of fir ms are si milar – f or exa m ple, if t hey are all sl o w t o a dj ust t heir prices f ol- lo wi ng a c ha nge i n t he mo ney supply – t he n real bala nces – t he mo ney supply de flate d by t he price level – c ha nge by a first-or der a mo u nt relative to a sit u- atio n wit h f ully o pti mizi ng price-setti ng be havior. T his first-or der c ha nge i n real bala nces, i n tur n, causes first-order c ha nges i n aggregate de ma nd, output and e mploy ment. For exa mple, suppose that the money supply increases by a fr a cti o n ε and a fraction of fir ms keep their prices unchanged. Each fir m’s losses, relative to f ully o pti mizi ng be havior, are a p proxi mately pro portio nal to t he sq uare of ε . If ε is .05, for exa m ple, its sq uare is q uite a s mall n u mber, .0025, so t he losses fro m price sticki ness are apt to be s mall. Ho wever, as- su ming money de mand is proportional to inco me, the change in real output is first- or der – pr o p orti o nal t o ε . ( Wit h f ully m a xi mizi n g b e h avi or by all fir ms, the change in the money supply leaves output unchanged.) Thus s mall devi- atio ns fro m co m plete ratio nality – i n dee d s mall a n d reaso nable deviati o ns fr o m co mplete ratio nality – reverse t he co nclusio n t hat expected c ha nges i n t he mo ney supply have no effect o n real i nco me a nd output. 3 1 Rule-of-t hu mb prici ng be havior takes ma ny for ms. For exa mple, staggered

2 8 See Nisbett a n d Ross (1980). 2 9 I n t his co ntext seco n d-order is the mathe matical representation of the concept s m all . C or- r es p o n di n gly, first-or der is t he mat he matical represe ntatio n of t he co ncept si g ni fic a nt i n size. 3 0 See Akerlof a nd Yelle n (1985a, b), Ma nki w (1985), Parki n (1986) a nd Bla nc hard a nd Kiyotaki (1987). 3 1 T he sa me results hold i n a nu mber of alter native fra me works. For exa mple, if fir ms set pro fit- maxi mizi ng ef ficie ncy wages, no mi nal wage sticki ness is a for m of r ule-of-t h u mb be havior wit h si- milar co nseque nces: t he losses to t he fir m holdi ng wages co nsta nt are seco nd-order, but s hocks to t he mo ney supply c ha nge real variables by a first-order a mou nt. I n Ma nki w’s for mulatio n s mall “ me n u costs”, w hic h are fixe d costs for maki ng a price c ha nge, i n hibit price c ha nges wit h effects o n equilibriu m output t hat are a n order larger t ha n t he me nu cost.

3 7 3 price ( wage) models, i n w hic h fir ms keep no mi nal prices ( wages) fixed for a perio d of ti me, corres po n d closely to descri ptio ns of price ( wage) setti ng pro- c ess es. 3 2 I n t h e Tayl or st a g g er e d c o ntr a ct m o d el, d uri n g e a c h p eri o d, h alf of all fir ms set a no mi nal price w hic h t hey mai ntai n for t he succeedi ng t wo-pe- ri o d i nt er v al. 3 3 A varia nt of t he staggere d co ntract mo del, d ue to Calvo, ass u- mes i nstea d t hat a fixe d no mi nal price is reset at ra n do mly varyi ng i ntervals. 3 4 Ne w Classical econo mists object to both renditions of the model, on the gro u n ds t hat s uc h price setti ng is not maxi mizi ng. 3 5 Of c o urse, t hey are rig ht: i nstead of keepi ng no mi nal prices u nc ha nged duri ng a fixed i nterval, Taylor’s a nd Calvo’s fir ms would do better by establis hi ng prices t hat vary wit hi n t he i nterval i n accorda nce wit h t he fir m’s expectatio ns of t he mo ney supply (ag- gregate de mand.) Such profit- maxi mizing behavior would again render mo- ney s u p ply c ha nges ne utral. Ho wever, price-setti ng ( wage-setti ng) strategies of t he Taylor / Calvo ty pe are near-ratio nal: t he s mall a mo u nt of no mi nal rigi dity t hat c haracterizes t hese mo dels is s uf ficie nt to allo w mo netary policy to be sta- bilizi ng, yet t he l osses relative t o a strategy t hat varies prices wit hi n t he prici ng i nterval are seco n d-or der. 3 6 T here are ma ny ot her for ms of near-ratio nal rule of t hu mb be havior t hat re nder mo netary policy ef ficacious. 3 7 3 2 Es pecially see Carlt o n (1986). 3 3 See Akerlof (1969), Fisc her (1977) a nd Taylor (1979). 3 4 See Calvo (1983). 3 5 See Barro (1977) for t his co mplai nt about staggered co ntract models. 3 6 See Akerlof a n d Yelle n (1991). Tec h nically, it t ur ns o ut t hat t he a m plit u de of t he b usi ness cyc- le, as measured by the standard deviation of (log) inco me rises due to Taylor’s staggered co ntracts by a n a mou nt t hat is proportio nal to t he sta ndard deviatio n of t he prici ng “error” ma de by Taylor’s fir ms. Mo netary policy ca n offset t his price sticki ness a n d re d uce b usi ness cycle volatility. B ut t he losses realize d by fir ms fro m t he use of Taylor-ty pe staggere d co ntracts are se- co n d-or der: pro portio nal to t he varia nce of s hocks to t he syste m. I n t his se nse, staggere d prici ng has a first- or der effect o n b ot h t he size of t he b usi ness cycle a n d t he sta bilizi ng pr o perties of m o- netary policy. B ut t he no n maxi mizi ng be havior w hic h allo ws mo netary policy to stabilize t he eco- n o my res ults i n l osses t hat are sec o n d- or der. 3 7 For exa mple, Gregory Manki w and Ricardo Reis (2001) have recently suggested that the re- spo nse of i nco me to mo netary s hocks is better explai ned by a “ near-ratio nal” model i n w hic h pri- ces (a nd/or wages) respo nd slo wly to ne w i nfor matio n t ha n by near-ratio nal, staggered price mo- dels i n t he Taylor / Calvo style. Slo w res po nse to ne w i nfor matio n may res ult fro m t he co nsi derable ma nagerial costs i nvolve d i n gat heri ng, processi ng, a n d s hari ng i nfor matio n i nvolve d i n t he price- setti ng process. (See Zbaracki et al. (2000), quoted in Manki w and Reis.) The Manki w- Reis for- m ulatio n resolves t hree para doxes prese nt i n ratio nal ex pectatio ns staggere d price mo dels. Sticky i nfor matio n yields t he e mpirically-observed lo ng lags of respo nse of i nco me to c ha nges i n mo ne- tary policy (Fried ma n (1948) a nd Ro mer a nd Ro mer (1989)); it is co nsiste nt wit h t he surprisi ngly slo w res po nse of i n flatio n to s hocks fo u n d i n esti mates of P hilli ps C urves ( Gor do n (1997)); a n d it fails to yiel d t he t heoretical perversity i n ratio nal ex pectatio ns staggere d co ntract mo dels of de- flati o nary p olicies t hat lea d t o i ncreases, n ot decreases i n o ut p ut ( Ball (1994)). Experi mental evidence suggests that the coordination proble ms involved in reaching a ne w equilibriu m may be exter nal as well as i nter nal to t he fir m. Fe hr a nd Tyra n (2001) co nducted ex- peri me nts i n w hic h price setters were give n payoffs derived fro m a near-ratio nal model wit h mo- nopolistic co mpetitio n. T hey fou nd t hat negative c ha nges i n t he mo ney supply caused co nsider- able output reductions when payoffs were deno minated in no minal ter ms. Subjects acted as if ot her price setters s uffere d fro m mo ney ill usio n, maki ng t he m, i n t ur n, rel ucta nt to c ut prices. ( A ne w approac h to t he depe nde nce of mo netary policy o n co-ordi natio n failure is i mplicit i n Ho witt a nd Clo wer (2000).) T his paper suggests t hat t he reactio n of prices to mo ney supply c ha nges i n- volves t he for matio n of expectatio ns co ncer ni ng t he respo nse of ot her price-setters to t he sa me s hock. Fe hr a nd Tyra n’s (2001) experi me nt poi nts to yet a not her for m of near-ratio nal be havior: price setters may fully maxi mize, but o n t he assu mptio n t hat ot her fir ms follo w sticky, rule-of- t hu mb prici ng be havior. Agai n, mo netary policy is effective i n c ha ngi ng output a nd e mploy me nt.

3 7 4 Near-ratio nal, r ule-of-t h u mb mo dels solve t he great p uzzle pose d by Robert Lucas regardi ng t he effective ness of mo netary policy wit h ratio nal expecta- ti o ns. 3 8 Ne w Classical Eco no mics fi n ds it dif fic ult to ex plai n more t ha n a fleet- ing relation bet ween money and output. The ne w behavioral econo mics, with a variety of pla usi ble near-rati o nal be havi ors, yiel ds a r o b ust relati o n bet wee n c ha nges i n t he mo ney supply a nd c ha nges i n output.

T HE P HILLIPS C URVE A N D T HE NAIR U Probably t he si ngle most i mporta nt macroeco no mic relatio ns hip is t he P hil- li ps C urve. T he “ price- price” P hilli ps C urve relates t he rate of i n flati o n t o t he level of u ne m ploy me nt, t he ex pecte d rate of i n flatio n, a n d variables affecti ng aggregate s u p ply, s uc h as t he price of oil or foo d. T he tra de-offs bet wee n i n- flatio n a nd u ne mploy me nt i mplicit i n t his relatio n de fi ne t he “feasible set” for monetary policy and thus play a decisive role in its for mulation. The P hilli ps C urve was first esti mate d f or Britai n, 3 9 t he n s ubseq ue ntly for t he U.S. 4 0 a nd ma ny ot her cou ntries. 4 1 T h e b asis of t h e P hilli ps C ur v e is s u p ply a n d d e m a n d. P hilli ps p osit e d t h at when de mand is high and une mploy ment low, workers can bargain for higher no minal wage increases than when de mand is lo w and une mploy ment hig h. Fir ms’ prici ng policies tra nslate wage i n flatio n (a dj uste d for pro d uctivi- ty) i nto price i n flatio n. For policy makers, t herefore, a d urable tra deoff exists bet ween inflation and une mploy ment. In the late 1960s, Milton Fried man (1968) and Ed mund Phelps (1968) added an i mportant ne w wrinkle. They argued that workers care about and bargai n for real, not no mi nal, wage gai ns: workers routi nely expect a nd re- ceive co mpensation for expected in flation, then bargain fro m there, de man- di ng hig her expected real wage gai ns at lo wer rates of u ne mploy me nt. Agai n, prici ng policies tra nslate wage i n flatio n i nto price i n flatio n. T he co nseq ue n- ce of t his s mall s hift i n ass u m ptio n – t hat workers bargai n for real, not no mi- n al w a g e i n cr e as es – is e n or m o us: i nst e a d of a d ur a bl e u n e m pl oy m e nt-i n fl a- tio n tradeoff, t here is no w just a u nique “ natural” u ne mploy me nt rate co n- sist e nt wit h st a bl e i n fl ati o n. Wit h “r e al- w a g e” b ar g ai ni n g, t h e l o n g-r u n P hilli ps curve – the une mploy ment/in flation co mbinations consistent with equality bet wee n actual a nd expected i n flatio n – is vertical because t here is o ne a nd o nly o ne u ne mploy me nt rate – t he “ natural rate” – at w hic h actual a nd ex- pecte d i n flatio n matc h. To see w hy t he lo ng-ru n P hillips curve must be vertical, i magi ne t hat a central bank atte mpts via monetary policy to hold une mploy ment belo w the natural rate. Wit h labor markets ab nor mally tig ht, workers de ma nd no mi nal wage increases in excess of expected in flation (plus nor mal real wage cu m

3 8 See L ucas (1972). 3 9 See P hilli ps (1958) a n d Li psey (1960). 4 0 See Gordo n (1970) a nd Perry (1970) for so me early esti mates for t he U nited States. 4 1 To give just o ne exa mple, Fla naga n, Soskice a nd Ul ma n (1983) esti mated t he P hillips Curve for ma ny differe nt c o u ntries.

3 7 5 pr o d uctivity gai ns.) Fir ms, i n t ur n, pass t he ass ociate d c ost i ncreases i nt o pri- ces, so t hat i n flatio n excee ds w hat workers i nitially a ntici pate d w he n t hey bar- gained. With une mploy ment belo w the natural rate, actual in flation there- fore exceeds expected i n flatio n. Ex post , workers have bee n fooled. So, over ti me, in flationary expectations, and in flation in turn, accelerates. With u ne mploy me nt held belo w t he natural rate, t he co nseque nce is ever accele- r ati n g i n fl atio n . Si milarly, t he Frie d ma n- P hel ps mo del pre dicts t hat a Ce ntral Bank atte mpting to hold une mploy ment above the natural rate indefinitely eve nt ually ca uses accelerati ng de fl atio n . O nly t he natural rate of u ne mploy- me nt yiel ds stea dy i n flati o n. Eco no mists acce pte d t he nat ural rate hy pot hesis re markably q uickly after it was first proposed by Fried man and Phelps in the late 1960s. Three things c o ns pir e d i n its f av or. First, it s e e m e d t o e x pl ai n r e m ar k a bly w ell t h e i n fl ati o n- une mploy ment experience of the 1960s and 1970s. At the lo w une mploy ment rates of t he late 1960s, i n flatio n rose, w hic h a p pare ntly drove u p i n flatio nary expectations, shifting the short-run une mploy ment inflation trade-off out ward. Thus the 1970s began with a much less favorable une mploy ment in- flatio n tra deoff t ha n t he 1960s. ( A nalysts ig nore d t he eq ually pla usible ex pla- natio n t hat as i n flatio n i ncrease d, as it di d i n t he late 1960s, wage bargai ns a n d price setti ng bega n to take i n flatio nary ex pectatio ns, w hic h ha d previo us- ly bee n ig nored, i nto accou nt.) 4 2 Seco n d, e m pirical esti mates of t he P hilli ps C urve yiel de d coef ficie nts o n past i n flatio n w hose s u m was not statistically dif- fere nt fro m u nity. T he i nfere nce was dra w n t hat t he lagged i n flatio n ter ms i n suc h esti mates correspo nd to expected i n flatio n, w hic h is a n autoregressive weig hte d average of past i n flatio n, a n d t hat t he coef ficie nt o n ex pecte d i n fla- ti o n i n d et er mi ni n g c urr e nt i n fl ati o n is o n e. 4 3 Fi n ally, t h er e is a bi as f or e c o- no mists to accept rationally-based null hypotheses, even though accepted o nly by t ests wit h r el ativ ely l o w p o w er. 4 4 Eco no mists s ho ul d not have acce pte d t he nat ural rate hy pot hesis so rea dily. T here are bot h t heoretical a nd e mpirical reaso ns to be hig hly suspicious. T heoretically, t he natural rate hypot hesis re mi nds me of a co m mo n diet-book rule of t hu mb. Accordi ng to t hat rule of t hu mb for every 3200 calories extra t hat we eat, we gai n a pou nd. For every 3200 calories less we lose a pou nd. T his al ways makes me i magi ne t wi n brot hers. O ne of t hese t wi n brot hers eats just e noug h to keep his weig ht eve n. T he ot her t wi n eats o ne more 100-calo- rie c o okie per day. If t he r ule of t h u m b is rig ht, after o ne year t he c o okie ea- ter is 11 pou nds heavier t ha n his brot her. After a decade he is 110 pou nds heavier. Fifty years later, s hould he live so lo ng, he would be 550 pou nds

4 2 T his alter native ex pla natio n was give n by Eckstei n a n d Bri n ner (1972), b ut di d not make it i n- to t he mai nstrea m. 4 3 We s ho ul d here note Sarge nt’s (1971) criticis m t hat t he coef ficie nt o n lagge d i n flatio n will not eq ual o ne i n a n acceleratio nist mo del if t he process ge nerati ng i n flatio n is stable, wit ho ut a u nit r o ot. 4 4 W e s h all s e e a n e x a m pl e of s u c h bi as b el o w w h e n w e r evi e w S u m m ers’ criti cis m of t h e a c c e p- tance of the rando m walk hypothesis based on failure to reject by tests with very lo w po wer agai nst alter native hy p ot heses.

3 7 6 heavier. Just as expected, the rule of thu mb does break do wn when extra- polate d over lo ng ti me perio ds: more acc urate re n ditio ns of t he relatio ns hi p bet wee n weig ht a nd calories s ho w t hat t he mai nte na nce of hig her weig ht re- q uir es e xtr a c al ori c i nt a k e. H a p pily t h e t wi ns’ w ei g hts will n ot div er g e f or ev er. Si milarly my guess is t hat for at least so me ba nd of u ne mploy me nt rates, i n- flatio n wo ul d asy m ptote to a co nsta nt val ue rat her t ha n accelerate or decele- r at e i n d e fi nit ely. S u c h a priori reasoning could be wrong, but the error fro m over-extrapolatio n of t he diet book rule of t hu mb war ns us t hat t he natural rate hypot hesis is rat her odd. At very lo w u ne mploy me nt rates, t he Fried ma n/ P helps predictio n of accelerati ng i n flatio n see ms quite possibly reaso nable a n d e m piri c ally r el ev a nt. 4 5 B ut I a m s us picio us abo ut t he t heory’s a p plicabili- ty when une mploy ment is high. My suspicio ns regardi ng t he natural rate hypot hesis are supported by a n e m piri c al f a ct, w hi c h r ev e als t h at its a p pli c a bility is n ot u ni vers al . U n e m pl oy- me nt i n t he U.S. for t he w hole of t he 1930s was i n dis p utably i n excess – s ure- ly gre atly i n excess – of a ny plausible natural rate. Accordi ng to t he natural rate hypot hesis, price de flatio n s hould have accelerated for t he w hole decade. T hat di d not ha p pe n. Prices fell for a ti me, b ut de flatio n sto p pe d after 1932; t here was no sig ni fica nt de flatio n for t he next te n years, despite extre mely hig h u ne m ploy me nt. T his evi de nce s uggests t hat, at least after so me ti me, at hig h levels of u ne mploy me nt a nd lo w i n flatio n rates, t he natural rate hypo- t hesis breaks do w n. S uc h a fail ure wo ul d not be terribly serio us for a t heory derive d fro m e m pirical observatio n, b ut it co nstit utes a serio us fla w for a re- latio ns hi p derive d fro m a priori pri nci ples, pri nci ples t hat are acce pte d beca u- se t hey are s u p pose d to be al ways a n d every w here tr ue. T he evide nce of t he 1930s is not u nique. Moder n eco no mies display si milar c haracteristics. For exa m ple, Pierre Forti n esti mates t hat fro m 1992 to 2000, the Canadian econo my experienced al most 12 points of une mploy ment in excess of a very co nservative 8 % esti mate of N AI R U. 4 6 D uri ng t hat sa me pe- rio d, i n flatio n average d a very lo w 1 1 /2 perce nt per year. Accor di ng to nat u- ral rate t heory, core i n flatio n s hould have decli ned by roug hly 6 perce ntage p oi nts, si nce a ty pical esti mate of t he P hilli ps c urve sl o pe is 1 /2. I nstea d, i n- flatio n decli ne d over t hat perio d by o nly .1 perce nt. Eco no metric evi de nce f urt her s uggests t hat t he nat ural rate t heory rests o n s hifty sa nd rat her t ha n bedrock. Ti me-varyi ng esti mates of t he natural rate s ho w t hat it c ha nges over ti me; b ut, eve n wit h allo wa nce for s uc h s hifts, esti- mates of t he natural rate possess hig h sta ndard errors. Staiger, Stock, a nd Watson (1997) co mpute a 95 % confidence interval for the US natural rate w hic h excee ds 5 perce ntage poi nts; t his is more t ha n t hree ti mes t he sta n dar d deviatio n of t he US mo nt hly u ne mploy me nt rate over t he last 50 years.

4 5 The occurrence of hyperin flation with lo w une mploy ment maintained sufficiently long is one predictio n of t he t heory. T he freque nt occurre nce of hyperi n flatio n see ms to support t he t heo- ry. But t hese hyperi n flatio ns have occurred w he n gover n me nts have lost fiscal credibility (a nd c o ul d o nly p ay t h eir d e fi cits by s ei g ni or a g e ). It m ay b e t h e l oss of fis c al cr e di bility, n ot t h e m ai n- te na nce of lo w u ne mploy me nt, w hic h is t he cause of t he hyperi n flatio n. 4 6 Observatio n d ue to Pierre Forti n i n Forti n, Akerlof, Dicke ns a n d Perry (2001).

3 7 7 In recent papers, Willia m Dickens, George Perry and I have explored t wo be havioral hypot heses t hat, co ntrary to t he natural rate model, produce a stable tradeoff bet ween une mploy ment and inflation at sufficiently high u ne mploy me nt a nd lo w i n flatio n rates. T he first hypot hesis is “pure Key nes”: w or k ers r esist, a n d fir ms r ar ely i m p os e, c uts i n n o mi n al p ay. T h e s e c o n d hy- pot hesis co ncer ns t he role of i n flatio nary expectatio ns i n wage bargai ns: we argue t hat, at very lo w i n flatio n, a sig ni fica nt nu mber of workers do not co n- si der i n flatio n s uf ficie ntly salie nt to be factore d i nto t heir decisio ns. Ho wever, as i n flatio n i ncreases, t he losses fro m ig nori ng it also rise, a n d t herefore a n i ncreasi ng nu mber of fir ms a nd workers take it i nto accou nt i n bargai ni ng. Key nes’ assu mptio n t hat workers resist no mi nal wage cuts was co nsiste nt wit h his i nt uitive u n dersta n di ng of psyc hology. T he ass u m ptio n also coi nci des wit h psyc hological t heory a nd evide nce. Prospect t heory posits t hat i ndivi- d uals eval uate c ha nges i n t heir circ u msta nces accor di ng to t he gai ns or losses t hey e ntail relative to so me refere nce poi nt. T he evi de nce s uggests t hat i n di- vi d uals place m uc h greater weig ht o n avoi di ng losses t ha n o n i nc urri ng gai ns. Kahne man and Tversky have de monstrated that many experi mental results w hic h are i nco nsiste nt wit h ex pecte d utility maxi mizatio n ca n be ratio nalize d by prospect t heory. Do w n ward wage rigidity is a natural i mplicatio n of pro- spect t heory if t he curre nt mo ney wage is take n as a refere nce poi nt by wor- kers i n measuri ng gai ns a nd losses. I n support of t his vie w, S ha fir, Dia mo nd a nd Tversky (1997) fou nd i n a questio n naire study t hat i ndividuals’ me ntal fra mes are de fi ne d not j ust i n t he real ter ms hy pot hesize d by classical eco no- mists b ut als o e x hi bit s o m e m o n ey ill usi o n. Nu merous e mpirical studies docu me nt t hat mo ney wages are, i n fact, do w n- ward sticky. Using panel data, Card and Hyslop (1997) and Kahn (1997) found that distributions of no minal wage changes are asy m metric around zero. Forti n fou nd a re markable pile-up of wage c ha nges at zero i n Ca nadia n data. Fro m 1992 to 1994, when Canadian in flation was 1.2 percent and the une mploy ment rate averaged 11.0 percent, only 5.7 percent of non- C OL A u nio n agree me nts had first-year wage cuts, w hereas 47 perce nt had wage free- z es. 4 7 I n detailed i ntervie ws i n Co n necticut, Be wley fou nd t hat ma nagers are willi ng to c ut no mi nal wages o nly as a last resort. 4 8 To i nvestigate w het her fir ms cut total co mpensation through benefit cuts as opposed to money wage cuts, Lebo w, Saks a nd Wilso n exa mi ned t he i ndividual i ndustries covered by the E mploy ment Cost Index: they found that benefit cuts are only a minor substitute for no mi nal wage cuts. 4 9 Using S wiss data Fehr and Goette found t hat eve n a seve n-year perio d of lo w i n flatio n a n d lo w pro d uctivity gro wt h di d not i ncrease t he freque ncy of mo ney wage cuts. 5 0 At lo w i n flatio n t here is a lo ng-r u n tra de-off bet wee n o ut p ut a n d i n flatio n if t h er e is av ersi o n t o n o mi n al p ay c uts. U nli k e t h e Fri e d m a n- P h el ps m o d el, i n w hi c h s u c h a tr a d e- off is tr a nsit ory, l o n g-t er m i n cr e as es i n i n fl ati o n (if it is cl os e

4 7 See Forti n (1995, 1996). 4 8 See Be wley (1999). 4 9 See Lebo w, Saks a nd Wilso n (1999). 5 0 See Fe hr a nd Goette (2000).

3 7 8 to zero) result i n sig ni fica ntly less u ne mploy me nt a nd more output. 5 1 T h e l o- gic goes as follo ws. I n bot h good ti mes a nd bad, so me fir ms a nd i ndustries do better t ha n ot hers. Wages need to adjust to acco m modate t hese differe nces i n econo mic fortunes. In ti mes of moderate in flation and productivity gro wth, relative wages ca n easily a dj ust. U nl ucky fir ms ca n raise t he wages t hey pay by less t ha n t he average, w hile t he l ucky fir ms ca n give above-average i ncreases. Ho wever, if pro d uctivity gro wt h is lo w (as it was fro m t he early 1970s t hro ug h t he mid 1990s i n t he U nited States) a nd t here is no i n flatio n, fir ms t hat need to cut t heir real wages ca n do so o nly by cutti ng t he mo ney wages of t heir e m ployees. U n der realistic ass u m ptio ns abo ut t he variability a n d serial corre- lation of de mand shocks across fir ms, the needed frequency of no minal cuts rises ra pi dly as i n flatio n decli nes. A n aversio n o n t he part of fir ms to i m pose no minal wage cuts results in higher per manent rates of une mploy ment. Beca use t he real wages at w hic h labor is s u p plie d are hig her at every level of e mploy ment when inflation is lo w, the une mploy ment rate consistent with sta ble i n flati o n rises as i n flati o n falls t o l o w levels. S pill overs pr o d uce a n ag- gregate e mploy ment i mpact which exceeds the e mploy ment changes in t hose fir ms t hat are co nstrai ne d by t heir i nability to c ut wages. T h us, a be ne- fit of a littl e i n fl ati o n is t h at it “ gr e as es t h e w h e els of t h e l a b or m ar k et.” Si mulatio ns of a model wit h i ntersectoral s hocks a nd aversio n o n t he part of fir ms to no mi nal wage c uts s uggests t hat, wit h realistically c hose n para me- ters, t he tradeoff bet wee n i n flatio n a nd u ne mploy me nt is severe at very lo w rates of i n flatio n, w he n productivity gro wt h is lo w. For exa mple, a per ma ne nt reductio n i n i n flatio n fro m t wo perce nt per year to zero results i n a per ma- nent increase in une mploy ment of approxi mately t wo percentage points. 5 2 Esti matio n of a P hilli ps c urve for t he U nite d States after Worl d War II, cor- responding to the si mulation model just described, gives si milar results. W he n t he P hillips curve t hus esti mated is used to si mulate t he i n flatio n ex- perie nce of t he 1930s, t he fit is s hocki ngly close to act ual U.S. i n flatio n ex pe- rie nce duri ng t he depressio n. 5 3 A co mparable si mulatio n of t he sta ndard na- tural rate model, i n co ntrast, cou nterfactually, s ho ws accelerati ng de flatio n t hroug hout t he 1930s. An alternative behavioral theory also generates a per manent tradeoff bet wee n i n flatio n a nd u ne mploy me nt at lo w i n flatio n. T his t heory is based o n t he i dea t hat beca use i n flati o n is n ot salie nt w he n it is l o w, a ntici pate d f ut ure c ha nges i n t he price level are ig nored i n wage bargai ni ng. 5 4 With monopo- listic co mpetitio n a nd ef ficie ncy wages suc h ig nora nce of i n flatio n w he n it is l o w is near-rati o nal. 5 5 T he psyc hology of j ust noticeable differe nces a n d cog-

5 1 See Tobi n (1972). 5 2 See Akerlof, Dicke ns a nd Perry (1996). 5 3 T his is do ne by seq ue ntially fee di ng i n t he si m ulate d i n flatio n of t he previo us perio d to derive a da ptively t he next perio d’s i n flatio nary ex pectatio ns. T he fit is so excelle nt t hat t here m ust be a co mpo ne nt of luck. 5 4 Past i n flatio n is i ncor porate d i n directly beca use wage bargai ns take i nto acco u nt t he wages pai d by c o m petit ors. 5 5 See Akerlof, Dicke ns a nd Perry (2000).

3 7 9 nitive psyc hology bot h s uggest t hat peo ple te n d to ig nore variables t hat are u ni m porta nt to t heir decisio ns. 5 6 Eco no metric esti mates of t he P hilli ps c urve w hic h allo w for t he possibility t hat past i n flatio n has a differe nt i m pact o n c urre nt i n flatio n w he n i n flatio n is hig h t ha n w he n it is lo w are co nsiste nt wit h t his hy pot hesis: at hig h i n flatio n, t he s u m of coef ficie nts o n past i n flatio n is cl os e t o o n e. 5 7 At l o w i n flati o n, t his s u m of c oef ficie nts is m uc h cl oser t o zer o. Si milarly, regressio ns usi ng s urvey meas ures of ex pecte d i n flatio n as a n i n de- pendent variable yield much higher coefficients on the expected in flation t er m at hi g h i n fl ati o n t h a n at l o w i n fl ati o n. 5 8 Not s ur prisi ngly t he n, w he n pe- riods of lo w a nd hig h i n flatio n are co mbi ned to esti mate a no n-li near model of the in fluence of in flationary expectations we find that their i mpact de- pe n ds o n t he rece nt history of i n flatio n. The de monstration by behavioral macroecono mics that very lo w in flation has the cost of per manently high une mploy ment and lo w output, has i mpor- ta nt i m plicatio ns for mo netary policy. Most of us t hi nk of ce ntral ba nkers as ca utio us, co nservative, a n d safe. B ut I co nsi der ma ny to be da ngero us drivers: to avoid t he o nco mi ng traf fic of i n flatio n, t hey drive o n t he far edge of t he road, keeping inflation too low and une mploy ment too high. During the 1990s, Canada had very lo w inflation and an unprecedented une mploy ment ga p – close to fo ur perce ntage poi nts – wit h t he U nite d States. 5 9 Europe has also had high une mploy ment and very lo w inflation. Japan has gone much furt her, allo wi ng de flatio n. Ce ntral ba nkers w ho accept t he textbook versio n of t he nat ural rate hy pot hesis s ho ul d follo w t he a dvice of Oliver Cro m well to t he Ge neral Asse mbly of t he C hurc h of Scotla nd: “I beseec h you i n t he bo wels of C hrist, t hi nk it p ossi ble y o u may be mistake n.” It is n o c oi nci de nce t hat t he leadi ng survey of cog nitive psyc hology uses t his citatio n to de mo nstrate a co m mon perceptual error: overconfidence. 6 0

U NDERSAVI NG It is co m mo n wis do m t hat peo ple save too little. To co m pe nsate for t his fail u- re, most developed cou ntry gover n me nts heavily support t he elderly i n reti- re me nt. I n additio n, a very large nu mber of e mployers require a nd subsidize

5 6 T his for mulatio n is also i n flue nced by t he public’s me ntal fra me regardi ng i n flatio n. S hiller (1997a, 1997b) has elicited t he differe nces i n me ntal fra me bet wee n t he public a nd eco no mists by q uestio n naire res po nses. 5 7 O ne is not, ho wever, necessarily t he magic nu mber for t he reaso ns noted earlier by Sarge nt (1971). 5 8 Suc h regressio ns address t he proble m suggested by Sarge nt t hat t he natural rate model s hould produce coef ficie nts o n expected i n flatio n t hat correspo nd to t he mo ney supply rule, a nd t hose coef ficie nts nee d not be eq ual to u nity. If ex pectatio ns are observe d wit ho ut error, t he coef ficie nt o n expected i n flatio n wit h natural rate t heory s hould be u nity. Error i n t he expectatio ns data s ho ul d bias its coef ficie nt do w n war d, b ut it s ho ul d not, as observe d, res ult i n c ha nges i n t he co- ef ficie nt, u nless t here are also c ha nges i n t he error of observatio n bet wee n periods of hig h a nd l o w i n fl ati o n. 5 9 3.8 perce nt fro m 1990 to 1999, accor di ng to Eco no mic Re port of t he Presi de nt, 2 0 0 0, Ta bl e B- 1 0 7. 6 0 See Nisbett a n d Ross (1980). T his book is o ne of t he lea di ng pri mers for t he psyc hology of be- h avi or al m a cr o e c o n o mi cs. C uri o usly, c o g nitiv e psy c h ol o gists h av e a m u c h m or e e m piri c al b asis for t heir t heories t ha n eco no mists.

3 8 0 pe nsio n co ntributio ns of t heir e mployees. Ma ny for ms of savi ng receive tax adva ntage. Eve n wit h t hese legs up, t he co m mo n wisdo m is t hat fi na ncial as- sets of most ho use hol ds still fall co nsi derably s hort of w hat t hey nee d to mai n- tai n t heir co nsu mptio n i n retire me nt. 6 1 F or N e w Cl assi c al e c o n o mi cs, s avi n g t o o littl e or t o o m u c h, li k e i nv ol u nt a- ry u ne mploy me nt, is a n i mpossibility, a straig htfor ward co ntradictio n of t he ass u m pti o ns of t h e m o d el. Si n c e s avi n g is t h e r es ult of i n divi d u al utility m a x- i mizatio n, it m ust, abse nt exter nalities, be j ust rig ht. Be havioral macroeco no- mics, i n co ntrast, has develo pe d t heoretical tools a n d e m pirical strategies to adva nce u ndersta ndi ng of suc h ti me-i nco nsiste nt be havior. A key t heoretical i n novatio n per mitti ng syste matic a nalysis of ti me-i nco nsi- ste nt be havior is t he recog nitio n t hat i n divi d uals may maxi mize a utility f u nc- tio n t hat is divorce d fro m t hat re prese nti ng “tr ue welfare.” O nce t his disti nc- tio n is accepted, “savi ng too little” beco mes a mea ni ngful co ncept. T he idea ca n be illustrated by t he a ncie nt myt h of t he le m mi ngs, w ho every fe w years are said to co nverge i n a deat h marc h, w hic h e nds wit h t heir fi nal plu nge i n- t o t he sea. 6 2 The alleged behavior of those le m mings reveals a distinction co m mon a mong psychologists, but rare for econo mists. Unless the le m mings ex perie nce a n u n us ual e pi p ha ny i n t hat fi nal pl u nge, t heir utility or welfare is give n by o ne f u nctio n; yet t hey maxi mize a not her. T hi nk abo ut it: t he po p ular vie w of savi ng, t hat peo ple u n dersave, is si mi- larly described. Deter mi ni ng w het her people save too muc h or too little i n- volves asking whether people, like the le m mings, have one (interte mporal) utility f u nctio n w hic h describes t heir welfare, b ut maxi mize a not her. 6 3 S uc h evi de nce as t here is s uggests pote ntially large differe nce bet wee n t he t wo co n- cepts. Hig h negative rates of ti me discou nt are necessary to explai n actual wealt h-ear ni ngs rati os. 6 4 Yet, questionnaire responses on the consu mption- savi ng tra deoffs t hat peo ple t hi nk t hey o u g ht to m a ke reveals a n i nterte m poral disc o u nt rate t hat is o n average slig htly p ositive. 6 5 T he hyperbolic discou nt fu nctio n, w hic h has bee n used to study i nterte m-

6 1 E nge n, Gale, a nd Uccello (1999, p. 97) reac h t he opposite co nclusio n. T hey co mpare t he ac- t ual wealt h wit h t hat derive d i n a calibrate d o pti mizatio n mo del. T heir preferre d calibratio n has a rate of ti me preference of three percent. With data fro m the U.S. Health and Retire ment Survey wit h a broad de fi nitio n of wealt h to i nclude all ho me equity, 60.5 perce nt of house holds have more t ha n t he media n opti mal wealt h i n t he calibrated model. But I would focus o n a n al- ter native result fro m t heir si mulatio ns. If we exclude ho me equity i nvest me nt i n spe ndable fi- na ncial capital, a nd assu me a zero rate of i nterte mporal ti me discou nt, o nly 29.9 perce nt of house holds reac h t he pre-retire me nt age of 60 or 61 wit h more t ha n t he opti mal media n wealt h for so meo ne of t heir age (p. 99, Table 5). Like t he discussa nts, bot h for e mpirical a nd a priori reaso ns, I vie w a zero rate of discou nt as more correct. T his co nfor ms to people’s stated pref- ere nce for no n- decli ni ng co ns u m ptio n at a zero rate of i nterest (see belo w) a n d it weig hts utility at differe nt ages o n a o ne-for-o ne basis. My c hoice to exclude ho me equity capital assu mes t hat retirees s ho ul d not have to leave t heir ho mes for fi na ncial reaso ns, or to reverse- mortgage t he m, as t h ey g et ol d er. 6 2 My 1946 versio n of The E ncyclopedia Brita n nica describes as fact t he marc h of t he le m mi ngs, w hic h “ never ceases u ntil t hey reac h t he sea, i nto w hic h t hey plu nge a nd are dro w ned.” 6 3 T his diff er e n c e is m a d e e x pli cit i n L ai bs o n ( 1 9 9 9 ). 6 4 S e e E n g e n, G al e, a n d U c c ell o ( 1 9 9 9, p p. 1 5 7 – 8 ). 6 5 S e e B ars ky, Ki m b all, J ust er, a n d S h a pir o ( 1 9 9 7, p. 3 4 ).

3 8 1 poral savi ngs c hoices, ca n be used to for malize t he disti nctio n bet wee n t he utility f u nctio n t hat describes act ual savi ng be havior a n d t he utility f u nctio n t hat measures t he welfare resulti ng fro m t hat be havior. T he hyperbolic fu nc- tio n ca pt ures t he dif fic ulty peo ple have i n exercisi ng self-co ntrol. I n co ntrast to t he ex po ne ntially decli ni ng disco u nt rates t hat are sta n dar d i n neoclassical theory, the hyperbolic function assu mes that the discount rates used to evaluate tradeoffs bet ween adjacent periods decline as the ti me horizon le ngt he ns: i n divi d uals use hig h disco u nt rates to eval uate o ptio ns t hat req uire a n i m mediate sacri fice for a future re ward a nd lo wer discou nt rates w he n t he sa me sacri fice is deferred i nto t he future. T hus, t hey are patie nt i n maki ng c hoices requiri ng grati ficatio n delays w he n t hose sacri fices are deferred; but i mpatient in delaying gratification in the short run. Because present con- su mptio n is more salie nt t ha n future co nsu mptio n, i ndividuals procrasti nate about savi ng. T he hyperbolic fu nctio n accords closely wit h experi me ntal fi nd- i n gs: H u m a n a n d a ni m al s u bj e cts ar e f ar l ess willi n g t o d el ay gr ati fi c ati o n i m- me diately t ha n to co m mit to s uc h delays i n t he f ut ure. 6 6 Two for ms of procrastination may result fro m hyperbolic discounting. “ Naive procrasti natio n” occurs w he n a n i ndividual assu mes i ncorrectly t hat her utility f u nctio n will be differe nt i n t he f ut ure. S he mistake nly projects t hat, alt h o ug h t o day is salie nt, t o m orr o w will be differe nt. S he fails t o see t hat to morro w’s self will be differe nt fro m today’s self, so t hat to morro w will be j ust as salie nt as t o day o nce it has m ove d o ne ste p cl oser. T he naive pr ocrasti- n at or mist a k e nly b eli ev es t h at s h e will s av e ( di et, e x er cis e, q uit s m o ki n g... ) t o- m orr o w, alt h o u g h s h e h as n ot d o n e s o t o d ay, a n d is s ur pris e d t h at t h e s a cri- fices deferred today are also deferred again to morro w. More sophisticated procrasti natio n takes t he for m of preproperatio n, accordi ng to t he ter mi no- logy of O’ Donoghue and Rabin (1999). The preproperator has fully rational ex pectati o ns a b o ut w h o her f ut ure self will be. S he says t o herself: t here is n o reaso n to save to day if to morro w is goi ng to be es pecially salie nt. If to morro w is es pecially salie nt t he n I will s pe n d w hatever savi ngs I have lai d asi de t o day w h e n it w as als o es p e ci ally s ali e nt. S o I s h o ul d n ot m a k e t h e s a cri fi c e t o d ay. Laibso n has use d hy perbolic disco u nti ng as t he basis of a researc h progra m on saving behavior and policy. With co-authors Repetto and Tobac man (1998) he has si mulated t he effects of differe nt tax i nce ntive progra ms i n a world in which consu mers preproperate. They esti mate that large positive welfare effects res ult fro m s mall c ha nges i n i nce ntives to save w hic h re d uce t he a mou nt of preproperatio n. Because of t his work t he regulatio ns regard- ing tax advantaged 401(k) savings plans have been changed. If fir ms so c hoose, workers may no w be auto matically e nrolled wit h a n auto matic default co ntributio n. Adoptio n of suc h pla ns sig ni fica ntly i ncreases pla n participa-

6 6 See Laibso n (1997), Laibso n, Repetto a nd Tobac ma n (1998), Strotz (1956), P helps a nd Pollak (1968), Loe we nstei n a nd Prelec (1992), a nd Ai nslie (1992). I n Akerlof (1991) I was regrettably una ware of earlier work on interte mporal inconsistency. In econo mics this includes Strotz (1956), Phelps and Pollak (1968), Thaler (1981), and Loe wenstein (1987). Loe wenstein and T haler (1989) give a n excelle nt early revie w of t he previo us literat ure o n dy na mic i nco nsiste ncy i ncludi ng t he psyc hological experi me nts a nd t heory. See also Ai nslie (1992).

3 8 2 tio n a nd ma ny workers mai ntai n t heir co ntributio ns at t he level of t he de- f a ult. 6 7 Besides t he popularity of social security a nd ot her progra ms t hat “force” co nsu mers to save, t he best evide nce of u ndersavi ng is probably t he observa- tio n t hat, upo n retire me nt, i ndividuals, o n average, reduce co nsu mptio n sub- st a nti ally. 6 8 In fact, consu mption at retire ment declines discontinuously. 6 9 Those with more wealth and higher inco me replace ment reduce their con- su mptio n by muc h less. T his fi ndi ng is dif ficult to explai n wit h t he sta ndard lif e cy cl e, e x p o n e nti al dis c o u nti n g m o d el. 7 0 T haler a nd Be nartzi (2000) have devised a savi ngs pla n to overco me wor- kers’ te n de ncy to procrasti nate a n d have teste d it o n a n ex peri me ntal basis at a mid-size ma nufacturi ng fir m: e mployees were i nvited to joi n a savi ngs pla n allo wi ng t he m to elect, i n a dva nce, t he fractio n of wage or salary i ncreases to be set asi de for savi ngs. Co nsiste nt wit h hy perbolic disco u nti ng, b ut not wit h t he sta ndard expo ne ntial model, workers c hose relatively modest savi ng out of curre nt i nco me but co m mitted to save large fractio ns of future wage a nd salary i ncreases. Wit hi n a s hort perio d of ti me, t he average savi ngs rate ha d d o u bl e d. 7 1

ASSET MARKETS K ey n es’ Ge ner al T heory w as t h e pr o g e nit or of t h e m o d er n b e h avi or al fi n a n c e vie w of asset markets. I n Key nes’ metap hor “professio nal i nvest me nt may be likened to those ne wspaper co mpetitions in which co mpetitors have to pick out the six prettiest faces fro m a hundred photographs, the prize being a warded to t he co mpetitor w hose c hoice most nearly correspo nds to t he aver- age prefere nces of t he co m petitors as a w hole.” 7 2 T h us stock markets are too volatile a nd also too respo nsive to ne ws. T his vie w of t he stock market co n- trasts wit h t he ef ficie nt markets mo del i n w hic h stock prices meas ure t he pre- se nt val ue of f ut ure ret ur ns a dj uste d f or risk. I n t he early 1980s Robert S hiller co nducted a direct test of t he Key nesia n excess v olatility hy p ot hesis. He reas o ne d t hat if st ock prices really are t he pre- dicte d val ue of ex pecte d f ut ure ret ur ns, t hey s ho ul d vary less t ha n t he dis- cou nted retur ns t he mselves. S hiller’s i nsig ht was a direct applicatio n of a

6 7 See Madrian and Shea (2001). 6 8 See Bernhei m, Skinner and Weinberg (2001) and Banks, Blundell, and Tanner (1998). 6 9 Suc h decli nes mig ht occur if retire me nt is associated wit h negative i nco me s hocks. Ber n hei m, Ski n ner, a n d Wei nberg (2001, p, 854) s uggest t hat s uc h a n a dj ust me nt is relatively mi nor. 7 0 Retirees, of co urse, obtai n greater leis ure, a n d t h us o ne mig ht ex pect a re d uctio n i n co ns u m p- ti o n as l eis ur e is s u bstit ut e d f or c o ns u m pti o n. It is dif fi c ult, b ut n ot i m p ossi bl e, t o e x pl ai n, i n a d- ditio n, w hy s uc h s ubstit utio n varies syste matically bot h wit h t he level of wealt h a n d wit h t he i n- co me re place me nt ratio. T his co ul d occ ur if t hose wit h a partic ular taste for leis ure i n retire me nt have by c hoice hig h i nco me replace me nt ratios a nd have accu mulated hig h levels of savi ngs. 7 1 Fro m 4.4 percent to 8.7 percent. This behavior is also explained by prospect theory by Kahne man and Tversky (1979). According to prospect theory the fra ming of decision- making is i m porta nt a n d peo ple resist taki ng losses. I n t his co ntext t hese e m ployees do not wa nt to take los- ses i n t heir co ns u m ptio n. 7 2 Key nes (1936, p. 156).

3 8 3 si m ple statistical pri nci ple: a goo d forecast s ho ul d have lo wer varia nce t ha n t he variable bei ng forecast. If t he weat her forecast has greater varia nce t ha n t h e a ct u al w e at h er, t h e w e at h er f or e c ast er s h o ul d b e fir e d. 7 3 Usi n g 1 0 0 y e ars of U.S. data o n stock prices a nd divide nds, S hiller (1981) co mpared t he va- ria nce of detre n de d stock prices to t he varia nce of t he detre n de d prese nt dis- co u nte d val ues of divi de n ds. 7 4 He fou nd just w hat Key nes would have expec- ted: t he sta ndard deviatio n of (detre nded) stock prices is five ti mes larger t ha n t he sta ndard deviatio n of (detre nded) discou nted divide nds. T hese re- sults have bee n co n fir med i n more sop histicated tests t hat properly allo w for t he no nstatio narity of bot h stock prices a n d t he prese nt disco u nte d val ues of divi d e n ds. 7 5 T he res ults of varia nce-bo u n ds tests not wit hsta n di ng, belief i n ef ficie nt mar- kets was s ustai ne d by e m pirical res ults s uc h as t he fi n di ng of i nsig ni fica nt serial correlatio n i n ret ur ns i n mo nt hly data. 7 6 Rejectio n of t he hy pot hesis t hat re- t ur ns are serially correlate d s uggests t hat t he stock market follo ws so met hi ng close to a rando m walk. In response, Su m mers (1986) sho wed in a model of “fa ds” – wit h serially correlate d deviatio ns fro m perfect markets – t hat serial c orrelati o n tests have very l o w p o wer: t he p o wer of s uc h tests is s o l o w as t o re- q uire 5,000 years wort h of data before it co ul d discri mi nate 50 perce nt of t he ti me bet ween the rando m walk hypothesis and a fad that would drive stock prices more t ha n 30 perce nt a way fro m fu nda me ntals 35 perce nt of t he ti me. 7 7 Bey o n d esta blis hi ng t he existe nce of excess v olatility, S hiller has als o exa- mi n e d its p ossi bl e c a us es. I n Irratio nal Ex ubera nce (1999), he revie ws t he ne ws coverage of t he stock market bubble of t he 1990s a nd explai ns ho w t he idea of a “ne w era” both in financial markets and the real econo my was propa- gated. As stock prices rose, t he “ ne w eco no my” ma ntra was tra ns mitted fro m perso n to perso n; i ndividual i nvestors acted o n t he opi nio ns of t he media,

7 3 For exa m ple, dra wi ng fro m a nor mal distrib utio n, t he forecast t hat yiel ds t he s mallest sq uare d deviatio n bet wee n t he act ual dra w a n d t he forecast is t he mea n of t he distrib utio n, w hic h is a co n- st a nt wit h n o v ari a n c e at all. 7 4 He extra polate d f ut ure divi de n ds for ti mes beyo n d his perio d of observatio n. For a si milar test also see Le Roy a nd Porter (1981). 7 5 S e e C a m p b ell a n d S hill er ( 1 9 8 7 ). Alt h o u g h S hill er’s to ur de force i niti ally s e e m e d t o cli n c h t h e case, t wo tec h nical proble ms cast a s hado w of doubt. T he first proble m is t hat detre ndi ng po- te ntially i ntroduces a serious bias i nto S hiller’s procedure: neit her stock price series nor di- vide nds are statio nary a nd a no nstatio nary series does not eve n possess a varia nce. T he seco nd proble m relates to t he s hort ness of S hiller’s sa mple a nd his extrapolatio n of future divide nds beyo nd t he prese nt. Alle n Kleido n (1986) s ho wed i n si mulated data t hat t he differe nce bet wee n t he varia nce of S hiller’s detre n de d stock price a n d of his divi de n d series is not large e no ug h to co n fide ntly reject t he ef ficie nt market null hypot hesis w he n retur ns follo w a ra ndo m walk. T he Ca m pbell-S hiller test allo ws for t he no nstatio narity of stock prices a n d divi de n ds, provi de d t he t wo series are coi ntegrate d. T his test is also vali d eve n if fir ms s moot h divi de n ds. T he hig h volatility of stock prices co ul d also be ex plai ne d by a hig h freq ue ncy cycle i n t he ex- pecte d real rate of ret ur n o n stocks. B ut s uc h a cycle is i nco nsiste nt wit h most sta n dar d classical models of t he eco no my, w here real retur ns are mai nly deter mi ned by t he state of tec h nology, a nd t he ca pital-labor ratio. I n t he sta n dar d classical mo del bot h tec h nology a n d t he ca pital labor ra- ti o c h a n g e sl o wly. 7 6 W here not i nsig ni fica nt i n t he statistical se nse, s uc h correlatio n see me d i nsig ni fica nt i n mag- nit u d e. 7 7 West (1988) si milarly de monstrated the lo w po wer of Kleidon’s efficient markets test using S hiller’s detre n de d data.

3 8 4 w hic h exaggerated t he effects of eco no mic fu nda me ntals suc h as t he i nter net on productivity. Such stock market bubbles are co m mon; they have occurred i n ma ny ot her cou ntries a nd freque ntly over t he course of history. I ndeed, Ki ndleberger’s accou nts of ma nias a nd pa nics a nd Galbrait h’s history of t he Gre at Cr as h of 1929 are disti ng uis he d pre decessors to Irratio nal Ex ubera nce. A seco n d major e m pirical fi n di ng t hat casts do ubt o n t he ratio nality of t he stock market is t he equity pre miu m puzzle. Over t he last t wo hu ndred years, t he retur n o n equity has bee n sig ni fica ntly hig her t ha n t he retur n o n bo nds. For exa mple, fro m 1802 to 1998 the real return on a value- weighted market equity i ndex was 7.0 perce nt per a n nu m co mpared to 2.9 perce nt for a relati- v ely ris kl ess s e c urity. 7 8 Over t he last 75 years, 1926-2000, t he real ret ur ns were 8.7 perce nt o n eq uity vers us 0.7 perce nt o n bo n ds, a ga p of 8.0 perce nt. A ga p of t his size is h uge: Siegel a n d T haler (1998) calc ulate t hat a $1,000 i nvest- ment made 75 years ago would have yielded $12,400 in bonds and $884,000 i n st o c ks. T his g a p is s o l ar g e t h at r ej e cti o n of r ati o n ality is d u c k s o u p: Wit h i nterte m poral maxi mizatio n of utility, t he margi nal utility of co ns u m ptio n to- day should equal the expected extra utility to morro w fro m foregoing one u nit of co ns u m ptio n to day. Wit h a co nsta nt relative risk aversio n utility f u nc- tio n, t his co nditio n i mplies t hat t he expected equity pre miu m s hould equal t he pro d uct of t he coef ficie nt of risk aversio n a n d t he covaria nce bet wee n t he gro wt h of co nsu mptio n a nd t he retur n o n stock prices. For reaso nable values of t he coef ficie nt of risk aversio n, ho wever, t his pro d uct is m uc h s maller t ha n t he equity pre miu m, t hus rejecti ng ratio nal co nsu mptio n be havior. T his re- jectio n is k no w n as t he equity pre miu m puzzle. 7 9 F urt her evi de nce of t he irratio nality of stock prices co mes fro m cross sec- tio n data. Si milar to S hiller’s ti me-series fi n di ng of excess volatility co u ple d wit h reversio n to t he mea n i n price/divide nds ratios, De Bo ndt a nd T haler (1987) fi n d reversio n to t he mea n of stock ret ur ns i n a cross sectio n: s ucces- sive portfolios for med by the previous five years’ 50 most extre me winners considerably underperfor m the market average, while portfolios of the previous five years’ 50 worst losers perfor m better t ha n t he market average. Ot her stock market a no malies, suc h as a 20 % o ne-day decli ne i n stock prices i n October 1987 i n t he abse nce of a ny sig ni fica nt ne ws also cast doubt o n t he ef ficie nt markets hy pot hesis. 8 0 Ass et m ar k ets ar e n ot o nly i m p ort a nt f or t h eir o w n s a k e, t h ey ar e als o i m- porta nt because t hey affect t he macroeco no my, t hroug h at least t hree c ha n- nels. First, t he value of assets affects wealt h a nd, i n tur n, co nsu mptio n. Seco nd, t he price of existi ng assets relative to t he price of ne w capital –

7 8 See Me hra (2001, p.1). 7 9 It is re markable t hat eve n t his weak test lea ds to rejectio n, si nce most t heories of co ns u m ptio n, w het her maxi mizi ng or not, would suggest co nsiderable correlatio n bet wee n t he rate of retur n o n stocks a nd t he rate of gro wt h of co nsu mptio n. For exa mple, suc h a correlatio n occurs if co n- su mers have a co nsu mptio n fu nctio n w hic h naively depe nds o n t heir wealt h, or, alter natively, if the sa me opti mis m that leads to high returns in the stock market also leads to consu mption bi nges. Parker (2001) s uggests a possible resol utio n of t he eq uity pre mi u m p uzzle. 8 0 See Ro mer (1993, p. 1112).

3 8 5 T o bi n’s q r ati o – aff e cts i nv est m e nt si n c e i nv est m e nt c a n b e vi e w e d as a n ar- bitrage bet wee n ne w capital stock a nd clai ms to si milar existi ng assets. 8 1 Fi nally, asset val ues affect t he c ha nces t hat fir ms will g o ba nkr u pt. Fir ms cl ose to ba nkruptcy fi nd it dif ficult, if not i mpossible, to borro w, a nd t hus co m- mo nly forego pro fitable i nvest me nt opportu nities. 8 2

P OVERTY A N D I DE NTITY If i nco me distributio n is a topic i n macroeco no mics, as ma ny have professed, then behavioral econo mics also offers insight on the most enduring macro- eco no mic proble m faci ng t he U nited States: t he disparity i n i nco me a nd so- cial condition bet ween the majority white population and the African- A merica n mi nority. As a legacy bot h of slavery a nd t he Ji m Cro w discri mi- natio n t hat follo we d it, poverty weig hs es pecially heavily o n Africa n- A meri- ca ns. T he black poverty rate of 23.6 perce nt i n 2000 was roug hly triple t he w hite rate of 7.7. 8 3 Despite co mprising only about 1/8 of the population, Africa n- A merica ns have al most 1/4 of all U.S. poverty. 8 4 T he reality is yet more disparate t ha n t hese statistics i ndicate because t he proble ms of t he poorest Africa n- A merica ns go beyo nd mere poverty. T hey i nclude extraordi- n arily hi g h r at es of cri m e, dr u g a n d al c o h ol a d di cti o n, o ut- of- w e dl o c k birt hs, fe male-headed households and welfare dependency. Statistics on incarcera- tio n i n dicate t hat eve n t he worst of t hese proble ms affect a sig ni fica nt fractio n of African- A mericans. Thus, for exa mple, about 4.5 percent of black males ar e eit h er i n j ail or i n pris o n. 8 5 T he black male i ncarceratio n rate excee ds t he w hite male rate by a factor of eig ht to o ne. 8 6 A n d t he life-ti me c ha nces of a black male yout h e nteri ng priso n exceeds 1/4. 8 7 Because sta ndard eco no mic t heory, i n our vie w, is i ncapable of explai ni ng suc h self-destructive be havior, Rac hel Kra nto n a nd I have developed models, based upon sociological and psychological observation, to understand the persiste nce of Africa n- A merica n disa dva ntage. O ur t heory stresses t he role of i de ntity a n d t he decisio ns t hat i n divi d uals make abo ut w ho t hey wa nt to be. I n our theory of minority poverty, dispossessed races and classes face a

8 1 See t he literat ure o n q t heory, es pecially i ncl u di ng Tobi n (1969), Abel (1982), Hayas hi (1982) and Su m mers (1981). 8 2 See Myers (1974), Jensen and Meckling (1976). La mont (1995) sho ws ho w dual equilibria may occur because of such dependence. 8 3 His p a ni cs h av e a si mil ar b ut l ess e xtr e m e hist or y of dis cri mi n ati o n. 8 4 See http:// w w w.census.gov/Press- Release/ w w w/2000/cb00-158.ht ml. 8 5 In 1996 there were 530,140 Black male prisoners and 213,100 Black Non- Hispanic and 80,900 Hispa nic jail i n mates of bot h sexes. T here were 462,500 male a nd 55,800 fe male i n habita nts of jails. Extra polati ng t he Black His pa nic rate at .3 a n d t he male /fe male rate for Black as t he sa me as W hite yields 211814 black males i n jail i n 1996. T he Black male populatio n was about 1/2 * (30 + .6 * 4.7) millio n = 32.82/2 = 16.14 millio n. T he net result is about 4.5 perce nt t he t he Africa n male po p ulatio n i n priso n or jail. So urce of i ncarceratio n rates: Correctio nal po p ulatio ns of t he US 1996, US Depart me nt of Justice, Table 5.7, p. 82. Source: http:// w w w.ce nsus.gov/sta- tab/ w w w/part1a.ht ml. 8 6 See w w w.hr w.org/reports/2000/usa/ Table3.pdf. 8 7 T his is a n esti mate base d o n i ncarceratio n rates i n 1993.

3 8 6 Hobbesia n c hoice. O ne possibility is to c hoose a n i de ntity t hat a da pts to t he do mi na nt culture. But suc h a n ide ntity is adopted wit h t he k no wledge t hat full accepta nce by me mbers of t he do mi na nt culture is u nlikely. Suc h a c hoi- ce is als o likely t o be psyc h ol ogically c ostly t o o neself si nce it i nv olves bei ng so meo ne “differe nt”; fa mily a nd frie nds, w ho are also outside t he do mi na nt culture are likely also to have negative attitudes to ward a maverick w ho has a d o pt e d it. T h us i n divi d u als ar e li k ely t o f e el t h at t h ey c a n n ev er f ully “ p ass.” A sec o n d p ossi bility is t o a d o pt t he hist orically- deter mi ne d alter native i de nti- ty, w hi c h, f or m a ny mi n oriti es, is a n o p p ositi o n al c ult ur e. E a c h i d e ntity is ass o- ciate d wit h prescri ptio ns for i deal be havior. I n t he case of t he o p positio nal ide ntity, t hese prescriptio ns are co m mo nly de fi ned i n ter ms of w hat t he do- mi na nt c ult ure is not. Si nce t he prescriptio ns of t he do mi na nt culture e n- d orse “self-f ul fill me nt,” t h ose of t he o p p ositi o nal c ult ure are self- destr uctive. T he i de ntity of t he o p positio nal c ult ure may be easier o n t he ego, b ut it is als o li k ely t o b e e c o n o mi c ally a n d p hysi c ally d e bilit ati n g. T his i de ntity-base d t heory of disa dva ntage is co nsiste nt wit h a co nsi derable bo dy of evi de nce. For exa m ple, it ca pt ures t he ce ntral fi n di ngs of st u dies by authors such as Anderson (1990), Clark (1965), Du Bois (1965), Frazier (1957), Hannerz (1969), Rain water (1970), and Wilson (1987, 1996). Read any African- A merican biography: the unco mfortable dance bet ween accep- ta nce a n d rejectio n i nvariably takes ce nter stage. T he i de ntity t heory of mi nority poverty has social policy i m plicatio ns t hat depart fro m t hose derived fro m sta ndard neoclassical t heory. For exa mple, t he sta ndard eco no mic t heory of cri me a nd pu nis h me nt i mplicitly argues for co mbati ng cri me by deterre nce: raise t he stakes hig h e noug h, as Califor nia di d wit h its “t hr e e stri k es a n d y o u’r e o ut” l a w, a n d t h e p ot e nti al cri mi n al will t hi n k t wi c e. B ut t h e pris o ns ar e f ull a n d cri m e h as n ot st o p p e d. A n i d e ntity- base d t heory s uggests, i n co ntrast, t hat large negative exter nalities fro m i n- carceratio n may offset t he s hort-ru n gai ns fro m deterri ng cri mi nal activity t hroug h toug her i ncarceratio n policies. 8 8 Pris o n its elf is a s c h o ol f or c o u nt er- cultural ide ntity, a nd t hus t he breedi ng grou nd for future cri me. Moreover, exter nalities i n i de ntity for matio n arg ue for progra ms to allay cri me before it has occurred. T hese i nclude, for exa mple, effective, easily accessed drug treat me nt a nd re habilitatio n progra ms a nd public jobs for i n ner-city yout h. Identity theory suggests that the benefits of increased expenditures for sc hools i n Africa n- A merica n neig hborhoods wit h hig h poverty rates are like- ly to be substa ntial: Africa n- A merica n c hildre n have bee n fou nd to be par- tic ularly res po nsive to differe nces i n teac her q uality a n d class size. 8 9 It may take t he extraordi nary teac her a nd close perso nal atte ntio n to sort t hroug h stude nt issues co ncer ni ng ide ntity i n additio n to coveri ng t he sta ndard cur- ri c ul u m. 9 0 Fi n ally, t h e e xt er n aliti es i nv olv e d i n i d e ntity f or m ati o n ar g u e f or af-

8 8 See Levitt (1996). 8 9 See Ferguso n (1998) o n t he effect of teac her quality a nd Krueger a nd W hit more (1999) o n t he eff e ct of cl ass siz e. 9 0 S e e D el pit ( 1 9 9 5 ).

3 8 7 fir mative actio n, beca use it is a sy mbol of welco me for Africa n- A merica ns i n- to t he w hite society t hat has rejecte d t he m for so lo ng. 9 1

C ONCLUSI ON It is no w t hirty years si nce t he revolutio n t hat bega n i n gro wt h t heory a nd then s wept through microecono mics. The ne w microecono mics is standard i n all graduate progra ms, half of a t wo-course seque nce. Adoptio n of t he ne w macroeco no mics has bee n slo wer, b ut t he revol utio n is co mi ng here as well. If t here is a ny s ubject i n eco no mics w hic h s ho ul d be be havioral, it is macroeco- n o mics. I have arg ue d i n t his lect ure t hat reci pr ocity, fair ness, i de ntity, m o ney ill usio n, loss aversio n, her di ng, a n d procrasti natio n hel p ex plai n t he sig ni fi- ca nt departures of real- world eco no mies fro m t he co mpetitive, ge neral-equi- li bri u m m o d el. T h e i m pli c ati o n, t o my mi n d, is t h at m a cr o e c o n o mi cs m ust b e base d o n s uc h be havioral co nsi deratio ns. K ey n es’ Ge neral Theory was t he greatest co ntributio n to be havioral eco no- mics before the present era. Al most everywhere Keynes bla med market fail ures o n psyc hological pro pe nsities (as i n co ns u m ptio n) a n d irratio nalities (as i n stock market s pec ulatio n). I m me diately after its p ublicatio n, t he eco- no mics professio n ta med Key nesia n eco no mics. T hey do mesticated it as t hey tra nslate d it i nto t he “s moot h” mat he matics of classical eco no mics. 9 2 B ut e c o- no mies, like lio ns, are wild a nd da ngerous. Moder n be havioral eco no mics has rediscovered the wild side of macroecono mic behavior. Behavioral econo- mists ar e b e c o mi n g li o n t a m ers. T h e t as k is as i nt ell e ct u ally e x citi n g as it is dif- fi c ult.

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