ECON430-Topic #4: Financial Literacy and Behavioral Finance

In economics, it is often assumed that people act rationally in their own best interest using all available information. In conducting monetary policy, this assumption often implies that people have a reasonable expectation of inflation and change their behavior in response to changes in interest rates. This topic is relatively open ended. What evidence is available for how people internalize and interpret monetary policy?

Janet Yellen gave a speech several years ago discussing the implications of the findings of behavioral finance on monetary policy. New Keynesian monetary policy largely relies on the behavioral principles laid out in Yellen’s speech.

John C. Williams (SF Fed) and other economists have also discussed the role played by behavioral principles in monetary policy. Rather than tell you what these speeches say, I’d like you to take a look through them and get your own impressions.

While some of this work does look at rational behavior v. imperfectly rational action, there is a specific argument against using behavioral models in central banking. Foremost, economists supporting rules-based behavior of central banks generally believe that central banks should not bother with worrying about what people think, and rather should respond only to concrete data. This is a relevant debate, and you should look for arguments on both sides of the debate.

Innumeracy and financial illiteracy also might play a role in the making of monetary policy. A huge number of American adults (and college students) are financially illiterate. (you can take the test here to see how you do). Why do central banks expend such effort in helping increase financial literacy at their regional banks? Look to uncover what the goal is of the regional (and Fed board) Fed financial literacy programs. There probably isn’t a single concrete answer as to why these exist, but you should make a point of trying to integrate this discussion with the behavioral discussion made above.

Questions you might answer

  • What are the main implications of the central bank acknowledging behavioral finance in the making of monetary policy (if they do)?
  • What facets of behavioral economics make an appearance in these models? Where else do they appear, and have economists made a compelling case that they should be considered in monetary policy.
  • What case can be made to ignore behavioral models when making monetary policy? Could it be that you are making a bigger mistake?
  • What role does financial illiteracy and innumeracy play in monetary policy? In other words, is there a good way for the central bank to conduct monetary policy effectively if people are not quite sure what the central bank is doing? What is the difference if people do not know much about the financial world around them?

27 thoughts on “ECON430-Topic #4: Financial Literacy and Behavioral Finance”

  1. With the rise of behavioral economics and its acceptance amongst members of the Federal Reserve, monetary policy is likely to see a huge change in the United States. While it is practical to create models in which economic actors make irrational or non-utility maximizing choices, it is also important to consider the flaws that might be inherent in using behavioral economic research to alter monetary policy. One problem that arises is that economists have used behavioral economic to justify different potential outcomes. As Janet Yellen noted, Akerlof, Dickens, and Perry released a paper that concluded in long-run periods of low inflation, the natural unemployment rate may be lower than if the inflation rate was a bit higher (1). However, in a different paper Akerlof concluded that sufficiently low inflation might lead to higher levels of unemployment (1). Both of these possibilities may properly predict how people without full information might respond to certain states of inflation but have totally different outcomes which shows how problematic it is to alter monetary policy given different research. Another reason this kind of monetary policy could be harmful is because of the possibility that individual actors may show a degree of irrationality while still creating an aggregate market in a state of optimization. For example, an economic study on the supply of hours a cab driver works may not be affected by demand (2). However, it may still be possible that in a long-term aggregate market, if demand is greater than supply, new cab drivers may join the market while individual cab drivers do not necessarily work more to meet demand. This implies that monetary policy by the Fed that might want to correct for individuals behaving irrationally might throw off a market that in whole is actually in equilibrium.

    1.) https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

    2.) https://www.cmu.edu/dietrich/sds/docs/loewenstein/NYCCabdrivers.pdf

  2. The Federal Reserve is aware of the low financial literacy level leading us to believe that they take into account these inaccurate and ineffective financial decisions when considering monetary policy decisions. The Federal Reserve is leading educational programs such as the “Promoting Awareness of the Importance of Financial Education and Literacy,” which includes public service announcements, a toll-free number, and an educational website (1). How does this not sound like the most effective and triumphed effort to help our nation learn? These lousy efforts by the Federal Reserve call us to question whether they truly believe that increasing the financial knowledge of Americans will help overall financial health. McCormick states, “the negative impact of financial illiteracy will only increase in the future, thanks to a few key trends.” He believes that the trends of safety net programs erosion, increasing family financial risks, and increasing obstacles to obtain financial independence will lead our nation into ultimate financial illiteracy (2). If the Federal Reserve wanted to get a noticeable increase in the financial literacy rates, they would implement more effective efforts. It is deemed important for Americans to find that motivation to educate themselves because Snider discusses importance of individuals not getting scammed or tricked down the wrong financial path during a period of deregulation (3). The ideas discussed by Thaler (2013) were though provoking, despite his vague implementation plan. This thought process behind a “just-in-time education,” seems reasonable since individuals tend to contribute the most time and effort when the financial issues are smacking them in the face (4). Therefore, the decision is not up to America to learn the complicated financial system, but up to the financial system to want to educate.

    (1) https://www.federalreserve.gov/newsevents/testimony/Bernanke20060523a.htm
    (2) https://www.huffingtonpost.com/douglas-p-mccormick/financial-literacythe-big_b_10264622.html
    (3) https://money.usnews.com/money/personal-finance/family-finance/articles/2018-02-06/why-financial-literacy-matters-in-an-era-of-deregulation
    (4) https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html

  3. Financial illiteracy could play a large role in citizen’s ability to understand and adapt to actions taken by the central bank. The magnitude of this problem can be measured by examining the scores of a financial literacy test taken by citizens. In a study conducted by the University of Pennsylvania, only one third of adults could answer three economic/financial questions correctly (nytimes 2013.) This is comparable to the knowledge people have concerning American politics. The electoral college can help with political illiteracy. This is because people who are more informed make the final decision. The same cannot be said for financial decisions. The citizen makes the final decision when it comes to investing, saving, and adapting expectations of inflation. I think this could explain why central banks put forth such effort in increasing financial knowledge (federalreserve.gov). Financial illiteracy can make conducting monetary policy more difficult. For example, if a central bank is trying to raise American’s expectations of inflation for the following year but only a one third of citizens understand the terms and the implications then expectations will adjust slower. I think financial literacy should be mandatory for high school students so they know to save early and what would happen to their accounts if inflation, deflation, recession etc. occurred. A financially literate public could help monetary policy become more efficient. If more people understood the way interest rates work or how inflation manifests, perhaps a change in interest rates or inflation would spur investment/consumption/saving in the way the central bank intended and expectations may adjust quicker and be more accurate.

    https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html
    https://www.federalreserve.gov/publications/minority-women-inclusion/2012-financial-literacy.htm

    1. Sam,

      I agree with you in that the fed has a role in increasing financial literacy because if people were financially literate perhaps events like the Great Recession would never have happened; if people knew that they would never be able to pay off their debts, perhaps they would never take out debts to begin with. What do you think?

  4. Although there are potential benefits to the introduction of behavioral finance under monetary policy, most of the benefits remain speculative at this time. Janet Yellen briefly introduces the hardships of incorporating behavioral economics when designing consumer disclosures. Her conclusion is that “such disclosures have not always been effective in conveying the key information that is relevant to such decisions.”(1) In relation to consumer disclosures, the main complication is how accurate behavioral economic research can be conducted to guide monetary policy. The problem has been identified and there has been evidence to prove it, but “the marginal product of further research in behavior economics is still likely to be very high.” (1) Given this knowledge, it is fair to assume that behavioral economics provides a helpful insight to policy, but rational models should not be regarded as extraneous since behavioral models are still in the works. John C. Williams discusses how the relationship between behavioral economics and asset prices can influence monetary policy and financial stability. He refers to behavioral evidence as a “growing body”, inferring that the research is not completely conclusive. (2) Since the evolution of behavioral finance has not yet produced a working, formalized model, this justifies the opinion that rational behavior and the Standard Economic Model should withhold under the formulation of monetary policy.

    (1) https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/
    (2) https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/

  5. Much of America is financially illiterate, which serves as a problem for the Fed. High financial illiteracy makes it a bit more difficult for the Fed to conduct monetary policy. This is shown by how much work the Fed does to improve the financial literacy of Americans such as creating community outreach programs and events for people to attend, all while working with schools to promote financial literacy. Central bank policies can even be affected by the simple existence of financial illiteracy, such as inflation targeting. Raising the expectation of inflation is hard for the bank to do when a majority of the population do not have an idea of how inflation may affect them. However, financial illiteracy is not a huge problem for central banks. For one, American financial illiteracy has been the norm throughout this country’s history (Plan Sponsor). It is unlikely that Americans are less financially literate today than in the past, when considering the amount of information that lies available to the world. The central bank makes adjustments to their polices to account for the average American. Second, while American financial literacy may be low, it does not mean Americans are incapable of making sound financial decisions, as they use something called heuristics. Heuristics are simple shortcuts and rules that people use to make decisions. These include things such as saving 10% of one’s paycheck. Heuristics allow for those with weaknesses in certain areas to cover their ignorance. While heuristics have some problems of their own, they prevent the American public from being completely vulnerable to their financial illiteracy.
    Sources:
    https://www.investopedia.com/terms/h/heuristics.asp
    https://www.plansponsor.com/lack-of-financial-literacy-remains-historic-american-challenge/
    https://www.federalreserve.gov/publications/minority-women-inclusion/2012-financial-literacy.htm
    https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html

  6. If the central bank decides to acknowledge behavioral economics it is, in a sense, accepting discretionary policy along with rules. The central bank has bounced back and forth between following rules over discretion in the past. Jason J. Buol and Mark D. Vaughan wrote an article for the federal reserve bank of St. Louis where they said rules offer time consistency, where the outcome demanded in the short run is met in the long run, and discretion creates confidence when the conditions of an economy are uncertain. Essentially discretionary policy is useful when there has been no formal evaluation of an economic situation in the past. Rules work when the normal fluctuations occur and the Fed uses measures to fix the issues for the short run. By accepting behavioral economics, they are accepting that the public’s response to monetary policy is not as rigid as it is described in rational expectations. People use references to fairness, envy, social status, and social norms to make their decisions. By understanding this, the fed may start to use more discretionary policy in the future if it seems it may be more effective than following rules of thumb that are very predictable and have been used for a long time. Janet Yellen noted that the public has become accustom to the Feds movements and sometimes produces inefficient results if the public is one step ahead of the Fed. By following behavioral economics, the Fed may gain the upper hand on the public and be able to institute more effective monetary policy in the future.

    https://www.stlouisfed.org/publications/regional-economist/january-2003/rules-vs-discretion-the-wrong-choice-could-open-the-floodgates
    https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/
    https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  7. We can use the entire history of our developed economy as an example that ignoring behavioral models when making monetary policy is not disastrous. Despite the large percentage of Americans who do not understand even basic finances, our economy is the largest in the world, and that is at least in part due to how monetary policy is formed in this country. While it is troubling that many do not seem financially competent enough to make such decisions as taking out loans and buying homes, the evidence of the effects of ignoring behavioral models when making monetary policy rest in our successful economy. However, some could argue if behavioral models were considered when making monetary policy post-recession 2008, the economy would be following its pre-recession trajectory. Taking behavior and the knowledge of large percentages of financial literacy into account could make the economy more efficient, grow faster, recover from recessions quickly. Because when the Fed announces that they are increasing interest rates, since they know a large percentage of people do not know what that means, they can overshoot the target rate and be back on the original economic path. That being said, there is a chance that the financial illiterate will suppress the effects of any monetary policy made because nominal factors affect real variables. Janet Yellen mentions that taking into account behavioral economics does have practical use (1). The Fed has begun to explore more effective ways of conveying information to consumers, citing that many mortgage borrowers didn’t understand much of finances. This increases financial literacy some, but not enough. Cooper argues that just increasing financial literacy will not solve any financial problems, that changing the legal system surrounding finances would be easier (2). Perhaps the solution to this overall problem is changing education so that more of the population is financially literate in conjunction with tweaking the legal system in the financial world thereby preventing something like the recession of 2008 from happening again, increase trust of the public in the banking system, and the Fed will not have to include that component when making monetary policy.

    1. https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/
    2. https://www.theatlantic.com/business/archive/2016/05/financial-literacy/480807/

  8. Many Americans are financially illiterate and do not understand the economic models that the fed uses when they make their policy decisions. Even though this is the case, many of the economic models used today assume that people have rational expectations about things like inflation. psychology and economics literature generally concludes that people do not make decisions in the fully rational way commonly envisioned in standard macroeconomic models. In a recent speech Jennet Yellen says that “research in behavioral economics is broadening and enriching our understanding of decision making. This research has the potential to strengthen the conceptual and empirical underpinnings of macroeconomic policy.” But is it a good use of the feds time to try to understand how people make financial decisions when so many Americans are financially illiterate, and do not understand what the fed is trying to do when they implement policies. It is more important for the to try to find ways to make more people financially literate then for the fed to try to figure of how and why people make their financial decisions.
    In a paper written by three business school professors: Daniel Fernandes, John G. Lynch Jr, and Richard Netemeyer, they came to the conclusion that “over all, financial education is laudable, but not particularly helpful. Those who receive it do not perform noticeably better when it comes to saving more, or avoiding ruinous debt.” Economists examining financial literacy would say according to their research, the vast majority of Americans lack basic levels of financial literacy, and George Washington University professor Annamaria Lusardi estimates that “more than one-third of wealth inequality could be accounted for by disparities in financial knowledge.” This means that improving financial literacy for the lower-income population and minority groups could improve inequality in America. Lusardi also says “It would be premature to conclude that all efforts at improving financial literacy are futile. Although no approach is perfect, three types of efforts seem worthy of more attention.” The first is called just-in-time education. Because learning decays quickly, it’s best to provide assistance just before a financial decision is made. High school seniors should receive help in how to think about a student loan, and how to make sure that the education bought with the loan offers good prospects for repayment. Just-in-time education can be offered at other crucial moments like getting a mortgage or a credit card. The second is offering simple rules of thumb for things like investing and saving for retirement, simple rules like saving 15% of your income. The third approach is to make our financial system more user-friendly. If we made choosing a suitable mortgage easier. If the financial system was more user-friendly then fewer households would find themselves in financial trouble. This third approach is the the one that offers the best prospects of immediate help for people. The financial services industry, either on its own or as required by government regulators, needs to find ways to make it easier for people to make sound financial decisions.

    Sources:
    1. https://www.federalreserve.gov/publications/minority-women-inclusion/2012-financial-literacy.htm
    2. https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html
    3. https://www.theatlantic.com/business/archive/2016/05/financial-literacy/480807/
    4. https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/

  9. The Federal Reserve ultimately conducts the U.S’s monetary policy, however the public plays a role on what kind of monetary policy is done. The issue with that being that there is a problem of financial illiteracy and innumeracy which can effect the publics’ view of monetary policy considering that a good portion of the American public do not completely understand the components and functions of monetary policy and the central bank. 24,669 participants took a statistical survey test that had measured financial literacy in April 2017 and the average test result across all ages was 63.17%(1). Theses financial literacy results imply that, on average, the U.S public is only about 63% competent on understanding basic financial concepts, which can be definitely troubling. Leaders from different political parties could potentially have support from voters who do not fully comprehend the impact of their suggested economic policies due to the voters’ lack of financial literacy and numeracy. A component of financial illiteracy is tax illiteracy. A proportion of the U.S public like tax cuts and completely oppose raises in taxes. This however is problematic due to that fact that continuous increases in tax cuts lead to a larger federal budget deficit, which in turn will lead to a decrease in savings and an increase in interest rates (2). This is an example of behavioral financial in effect because people’s biases, whether it be formed from a lack of financial knowledge or political affiliation, lead them to being adamant against tax increases even though the increase would be beneficial in decreasing the budget deficit (3). This could possibly lead to some politicians who want to be elected for office to ignore their economical beliefs in order to be elected or the Federal Reserve restraining from conducting contractionary policy due to potential public backlash.

    (1) https://www.financialeducatorscouncil.org/financial-literacy-statistics/
    (2) https://www.washingtonpost.com/posteverything/wp/2017/04/14/people-dont-like-paying-taxes-thats-because-they-dont-understand-them/?utm_term=.880c5cfd17a8
    (3) https://www.vanguard.co.uk/documents/portal/literature/behavourial-finance-guide.pdf

  10. There are a few main implications of the integration of behavioral finance into the structure of monetary policy. As a core element of every credible macroeconomic model, the Phillips curve would certainly be affected by behavioral finance because of the role it plays in policy determination. Yellen argues that behavioral economics can aid our comprehension of the Phillips curve because “…better models of the inflation process help improve our forecasts and clarify limitations on what monetary policy can do” and because “… the theoretical underpinnings of the Phillips curve are important in understanding what central banks should do”[1]. So in other words the integration of behavioral economics into the Phillips curve would not only help determine what is feasible for monetary policy but would also help with the interpretation of the constraints, specifically their price stability mandate and their assessment of the welfare costs of fluctuations in output and inflation. Yellen also argues that behavioral economics helps provide new justifications for wage and price rigidity such as fairness, envy, social status and social norms, which improves macroeconomic models by altering the method of expectations formation. John C. Williams also argues that understanding consumer behavior is significant for the advancement of monetary policy because “…recognition that people behave in this way can move us a long way closer to understanding how asset price booms and busts can emerge and how policy actions could influence that process”[2]. All in all, the integration of behavioral economics into macroeconomic models would have positive implications because it adds new variables that can aid in the instrumentation of monetary policy.

    Sources:
    [1] https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

    [2] https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/

  11. The Federal Reserve is addressing behavioral finance/economics to improve their models, increase the effectiveness of their policies and decrease the difficulty in reaching their dual mandate. The Federal Reserve could choice to ignore the errors caused by behavioral finance if they were random and nonsystematic. The literature on behavioral finance points to the presence of systematic deviations leading to the Federal Reserve needing to adjust their models to account for systematic deviations. Better models should lead to more effective monetary policy. Furthermore, financial literacy will allow the Federal Reserve to manipulate consumer expectations better. The effectiveness of monetary policy depends on shifting expectations for future conditions, hence the more financially literate individuals are, the closer consumer expectation shifts will be to what is intended by the Federal Reserve. Finally, increased financial literacy could provide better economic stability. Williams (2014) notes that behavioral economics can explain why asset bubbles occur. As seen with the Great Recession, asset bubbles can cause spillover effects into the entire economy causing deviations from full employment and two percent inflation. Understanding why bubbles occur to try to stop them from happening could help prevent some of the drivers of dramatic deviations from full employment and inflation making central banker’s job easier.

    Sources:
    (1) https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/
    (2) https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/
    (3) https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/
    (4) https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html

  12. When looking at smaller scale issues behavioral economics can be defined by the financial illiteracy we are seeing as a country today. As Marianne Cooper points out, financial illiteracy is a costly epidemic in America, and can be quantified through a study conducted on credit card debt amongst the less educated demographic of our country (1). While fees and credit card debt aren’t exactly indicative of our country’s economy on a macro scale, it does tell a bigger story in regards to financial illiteracy. Behavioral economics is a variable that must not be overlooked when strategizing for monetary policy. After all, if so many are unsure of what a change in inflation targets or interest rates mean for them as individual, how can we speculate how they will react? The easiest solution to help combat financial illiteracy is improvements in education. Richard Thaller suggests the implementation of basic financial education at a high school level, noting that interest rates are just as important as geography or many of the other basics covered at that education level. However, he also addresses the need for more user-friendly financial tools (2). With the technology available to us today, it is a crime that more institutions haven’t provided a platform that explains basic concepts and shows people exactly what they’re doing from constructing a 401k to assessing saving options. The board of governors of the Federal Reserve System has set out to improve the statistics on financial illiteracy, which in turn will help the Fed conduct better research towards behavioral economics.

    (1) https://www.theatlantic.com/business/archive/2016/05/financial-literacy/480807/
    (2) https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html

  13. Financial illiteracy is a problem in the United Sates. One in five Americans are financially illiterate. (1) Studies show that investors do not even understand the most basic concepts such as inflation, interest rates, time value of money and so on. (2) Only one-third of Americans are able to pass the most basic test of financial literacy. (3) The lack of financial literacy results in financial hardship in the economy. (4) The role of central banks is to minimize the financial hardship in the economy. (4) However, central bank’s monetary policy is less effective if people do not know what central bank is doing. For example, survey-based method of inflation expectations is important for monetary policymakers. (5) However, the results will not be accurate if people are financially illiterate and innumerate. Another example is that the central bank enacts monetary policy to boost spending by lowering the interest rate. The Fed’s intention to stimulus spending will be less effective if people do not know that lowering interest rate means they can borrow money more easily to make big purchases.

    Citations:
    1. https://www.theguardian.com/money/2017/may/27/financial-illiteracy-young-people-oecd-study
    2. https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part2.pdf
    3. http://fortune.com/2016/07/12/financial-literacy/
    4. https://www.rba.gov.au/publications/bulletin/2008/sep/pdf/bu-0908-3.pdf
    5. https://www.clevelandfed.org/newsroom-and-events/speeches/sp-20060908-inflation-inflation-expectations-and-monetary-policy.aspx

  14. Behavioral economics is an emerging sub-field within the social science of economics; primarily focusing on the psychology (in particular the rationality) of the economic agent. A commonly used assumption in many economic models is that people are indefinitely rational in the sense that they take in all possible information and make self-interested decisions on the margin (benefits>costs). Although this assumption is not realistic (1), the idea makes it easier to study decision making trends of economic agents in response to different economic shocks. The monetary authority, in order to make more effective policy, must incorporate these irrational behaviors into their forecasting models. In supplement to the irrational behavior of economic agents, the monetary authority must also account for financial ignorance of the population. Only 19 percent of American high school graduates possess basic financial knowledge (2). This illiteracy can make the dual mandate of the central bank more challenging. If the public can’t understand what you are talking about when you make announcements regarding policy decisions, how can you expect the public to react in a rational manner. The Fed understands that a better-informed public makes monetary policy more effective, and therefore have made it an initiative to educate the upcoming youth about financial literacy (3). A well-educated population can decrease the degree of irrationality associated with people’s decision-making processes, and allow the Fed more power in policy decisions. [For example, If I, as an economic agent, comprehend that the Fed announcing an interest rate drop spurs investment, will proceed to invest in non-monetary assets (NMAs). Why? I know that along with decreases in the FFR comes higher inflation (devaluation of money). I am better off than I would have been just holding currency, and through my investing, the Fed is getting their desired result of increased investment and a more effective expansionary policy.

    https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/#_ftn5 (1) [Specifically the conclusion]
    https://www.theatlantic.com/business/archive/2016/05/financial-literacy/480807/ (2)
    https://www.federalreserveeducation.org/ (3)

  15. I think that it is a wise idea for the Central Bank to incorporate behavioral models into its decision making and monetary policy. However, it would be a bigger mistake to include them if they do not fix one key issue in my mind. This issue is the financial illiteracy problem in our country. If we include behavioral models we still need a base for which to start from with them and some general idea of what people will do. If people are not financially literate, then they may miss their mark because even what we expect people to do they will not causing more issues than we already had. In John C. Williams’s speech, he discusses much about how peoples expectations of the future can effect what will happen with the economy. For example, he says, “to relax the assumption of rational expectations and allow people’s decisions to be driven by their perceptions of what the future may hold” and then goes on to talk about data backing this up (1). This is great for extremely general items but if people do not understand what they are looking or seeing in the market one bad expectation could send the market tanking. Janet Yellen goes on to say in her speech, “Behavioral macroeconomic models have extended this agenda, both by providing new justifications for wage and price rigidity and by incorporating additional departures from the frictionless benchmark,” and then talks about how its still up in the air which is best empirically (2). This shows behavioral does have benefits in understanding markets, but if we were to back the wrong horse it would cause to much faith in the wrong part. Including behavioral models I believe is important and the future, but we need more data on what is best to include or our economies could see massive issues.

    1. https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/
    2. https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  16. With the increased prominence of behavioral economics, the assumption that all individuals are rationally self-interested has been relaxed to some extent. The relaxation of this assumption means that bias is likely present when people are forming future expectations for things. This is particularly true in the case of inflation, where expectations have been shown to affect the real cost of borrowing. It is now crucial to the long-term success of monetary policy to ensure that the public’s inflation expectations are well grounded. According to the Cleveland Fed, expectations “help policymakers gauge the public’s perception of the central bank’s commitment…” (1). This commitment is key; if the public feels the Fed is bluffing, their expectations will change in such a way that negates any real impact. This changes the way monetary policy is enacted as more importance now lies on whether or not the Fed is trusted to do what it says. Most importantly, a central bank should never surprise people with sudden changes in policy. As an example, the Fed has remained committed to its target level of inflation at 2% despite the consistently lower averages experienced in Bernanke and Yellen’s terms (2). 2% may be an arbitrary value, yet it’s adhered to for a variety of reasons that can be partially explained by behavioral economics. Loss aversion states that people are often willing to incur higher costs to prevent losses of equal or lesser value (3). People also associate negative feelings with higher nominal prices. For these reasons, changes in the targeted inflation by the Fed in either direction will be largely unpopular.

    1. https://www.clevelandfed.org/newsroom-and-events/publications/economic-trends/economic-trends-archives/2009-economic-trends/et-20091105-inflation-and-inflation-expectations.aspx
    2. https://www.bloomberg.com/news/articles/2017-07-18/fed-s-long-run-miss-of-inflation-goal-undermines-rate-hike-case
    3. https://www.nngroup.com/articles/prospect-theory/

  17. In her speech at the Federal Reserve bank of Boston conference, Yellen stated that, according to behavioral research on how realistic formations of expectations differ from the rational models, the long run Phillips curve may take the negatively-sloped shape of the short run Phillips curve over a low enough codomain of inflation because low inflation does not register in people’s decision-making (1). This implies that for a “sufficiently low” level of inflation, there is a negative trade-off between inflation and unemployment, and that policy-makers can lower the natural rate of unemployment through monetary mechanisms. Hence, over this low codomain, an unemployment level lower than the natural level could be maintained without inflationary pressure. This may be a plausible description of the Phillips curve behavior of the U.S economy in recent years. The average PCE core annual year on year inflation rate from 1984 to January 2007, the year of the crisis, was 2.59 (2); the same measure has been about 1% below that average every year since the recession ended (2009). The annual unemployment gap, or the difference between actual rate of unemployment and the natural rate, averaged 0.287% from 1984 to 2007, The gap from 2015 to 2017 was 0.077%, roughly four times lower, while maintaining an inflation level of about 1% below the pre-recession average (3)(4). If this behavioral model of expectations is a more accurate way of portraying how people respond to low inflation than the rational expectations model, then the economy could currently be within a range of inflation such that monetary policy that maintains that inflation within this range maintains permanently higher output than levels above and below the range. All this without risking inflationary pressures.

    1. https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/
    2. https://fred.stlouisfed.org/series/BPCCRO1Q156NBEA#0
    3. https://fred.stlouisfed.org/series/UNRATENSA
    4. https://fred.stlouisfed.org/series/NROU#0

  18. How people think about monetary policy, and their subsequent financial decisions based on historical data or future expectations, are essential considerations in central banking models. Discretionary monetary policy decision-making is subject to “human error” since even “the most expert policymakers… suffer from a variety of biases” [1][2]. However, it is preferable to rules-based monetary policy, since the avoidance of rational or irrational behavior in their models is one of its biggest flaws. Monetarist Athanasios Orphanides argues that rules-based policies, such as the Taylor rule, rely too heavily on real-time data, and found that “real-time policy recommendations” from rules-based models “differ considerably from those obtained with the ex post revised data” [3]. This may be because econometric and equation-based models which solely implement data lack the comprehensive evaluation skills of policymakers in central banks, who can make judgements based on not only the data provided, but on the thoughts and expectations of the rational or irrational citizen as well. The New Keynesian Phillips curve, a “constrained discretion” model used by the Federal Reserve, has recently been altered to better account for the semi-rationality of the masses: it now “assume[s] that all agents act as if they had rational expectations, but most use outdated information” [4][5]. Discretion allows for central bank members to consider the expectations of the rational and the irrational, and adjust their models accordingly. Meanwhile, rules ignore the human component of the economy entirely, which is a major shortcoming. The behavior of the economy mimics the behavior of the agents within it, and to look at data alone and disregard the agents is similar to ignoring half of the equation.

    Sources:
    [1]: https://www.forbes.com/sites/anaswanson/2014/08/25/the-advantages-and-disadvantages-of-rule-based-monetary-policy/#3e4868484c2c
    [2]: https://www.alt-m.org/2015/08/07/rules-versus-discretion-insights-behavioral-economics/#3
    [3]: https://www.federalreserve.gov/pubs/feds/1998/199803/199803pap.pdf
    [4]: https://www.rieti.go.jp/jp/publications/dp/15e007.pdf
    [5]: https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  19. The Fed’s job is to promote and maintain financial stability within in the United States. One may be inclined to believe that they can achieve their goals in a vacuum. It is easy to believe that the Fed can do their and the general public doesn’t have to wrestle with the economic and/or financial implications. However, financial literacy is paramount to the Fed’s monetary policy. When given a simple quiz on financial literacy only a third of all American adults could answer all questions correctly (1). Moreover, researchers have found that those that are most economically vulnerable have the least financial knowledge and that those that had low levels of debt literacy would conduct themselves in a way as to accrue unnecessary charges (2). It is poor financial literacy and the effects thereof that helped cause the 2008 financial crisis (3). Unwitting and financially illiterate people were lead to believe that they could own their own homes. this caused them to take out loans they couldn’t afford. In addition, current home owners were taking out home equity loans and other financial products linked to the value of their houses at the same time. Janet Yellen herself mentioned that research in behavioral economics regarding the information lenders must provide bowers was of the utmost importance (4). 2008 was a prime example of financial illiteracy running rampant and the Fed adjusting their monetary policy accordingly. The new bubble may lie in auto loans or student loans. It is therefore important to increase the financial literacy through both just-in-time education or by given financial rules of thumb, also called heuristics.

    1 – https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html
    2 – https://www.theatlantic.com/business/archive/2016/05/financial-literacy/480807/
    3 – https://www.thebalance.com/mortgage-crisis-overview-315684
    4 – https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  20. The financial literacy has a correlation with rational financial decisions, according to Fed Chairman Ben Bernanke’s testimony in 2006 (1). However, financial literacy is a major problem in the US, as two-third of the American cannot pass a simple financial literacy test (2). The central bank may not conduct monetary policies effectively while most of Americans’ financial well-being are not stable. The low rate of essential financial skills can result that poor performance in personal financial management like miscalculating budgets, investing unwisely, spending high with saving less, underestimating mortgages and loans, etc. For example, according to Dani Pascarella, a contributor of Forbes, there are several statistic findings that should be concerned about how low financial literacy impacts to many Americans’ lives: 44% of Americans do not have enough cash to cover $4000 emergency, 43% student loan borrowers are not making payments, 38% of US households have credit card debts and 33% of American adults have $0 saved for retirement (3). Ben Bernanke also states that “Informed financial decision making is also vital for the healthy functioning of financial markets” (1). Financial literacy can benefit for not only the individuals but also the society as a whole. When people do not know much about the financial world around them, it is very important that they may not understand what or how central bank attempts to stabilize the economy.

    (1) https://www.federalreserve.gov/newsevents/testimony/Bernanke20060523a.htm
    (2) http://www.usfinancialcapability.org/results.php?region=US
    (3) https://www.forbes.com/sites/danipascarella/2018/04/03/4-stats-that-reveal-how-badly-america-is-failing-at-financial-literacy/2/#a789b1976bc6

  21. If the central bank acknowledges behavioral finance in their policy making process, it would call for the massive reexamination of the majority of the models presently used today by central bankers. As Yellen pointed out, common economic structures such as the Phillip’s curve would have to be revisited and edited to accommodate the new guidelines and variables introduced by behavioral thought. This goes even farther to the goals of the central bank and what they actually focus on in the long run. Long story short, this means that the Federal Reserve and any banks who follow the same mode of thought are going to have to rethink almost all their operations. They would have to start to employ the help of not just economists and statisticians but also psychologist and anthropologist. The study of economics would become about being in the mind of the consumer and being able to predict the irrational decisions of the average American. Hitting targets would become a game of trying to adjust expectations rather than interest rates and fiscal spending. The tools of the game would be completely different than before. The Federal Reserve would be concerned about keeping people’s expectations and beliefs in line with what is desired by the central planners and away from any train of thought that might be harmful to the economy. The aim would be to keep everyone in the proper state of mind that doesn’t risk danger to the economy and also a drift from the maximum potential for growth.

    https://www.frbsf.org/our-district/files/0928.pdf
    https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/

  22. Most modern economic models use rational expectations to model the behavior of individuals. These models assume individuals are basing their expectations of the future by making rational decisions and systematically updating these expectations when new information is observed. While rational expectations might be able to model the behavior of an economist or mathematician, everyday citizens would likely be uncapable of making the calculations needed to achieve these expectations. If the central bank were able to incorporate behavioral economics into its models of decision making, it would likely result in more accurate forecast. With more variables to describe decision making, behavioral macroeconomic models have been able to incorporate new justifications for wage and price rigidity (1). The ability behavioral economics to better describe the decision- making process of individuals could drastically improve models used by the central bank. In a 2007 panel led by President Janet Yellen she advocated the incorporation of behavioral economics, stating that “this research has the potential to strengthen the conceptual and empirical underpinnings of macroeconomic policy.” (1).
    (1) https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  23. The debate around behavioral economics (BE) being included or avoided in the production of monetary policy is still being discussed today. While there is no universal agreement if including BE into models is productive or damaging, the amount of literature surrounding BE has been growing since 1979 (1). Certain principles of non-standard human behaviors such as loss aversion, reciprocity norms, and overconfidence have been shown to occur in individual decision-making (1) have been shown to curb rationality. It is also worth to note that financial illiteracy in the United States is troubling given that when asked, some adults cannot understand basic questions about economics (2). People in favor of BE such as Kahneman and Tversky have focused on aspects such as prospect theory (people make decisions based on potential value of losses and gains rather than outcome (3)). They also have researched heuristics/biases in their book “Thinking Fast and Slow,” where they argue from a cognitive-psychological standpoint that overconfidence and loss aversion play a large part in human decision-making (4). Some critics of BE relating to loss aversion in consumption argue that including the assumption of loss aversion to wage bargaining can create multiple-equilibria in an economy (1). I personally end up agreeing with aspects of both. Kahneman and Tversky make a convincing argument that patterns of loss aversion regularly occur in humans and in models, (this is also agreed on by the critics in (1). Suggestions such as applying mechanisms like expansive monetary policy during contractions and a flatter aggregate supply curve can help include external habits in consumption in models.

    (1) https://ideas.repec.org/p/baf/cbafwp/cbafwp1501.html
    (2) https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html
    (3) https://www.princeton.edu/~kahneman/docs/Publications/prospect_theory.pdf
    (4) https://www.scientificamerican.com/article/kahneman-excerpt-thinking-fast-and-slow/

  24. In the world today, consumer expectations can have an impact on the economy. For instance, when the Fed or Central Bank makes an announcement on a new monetary policy, it is only a matter of time before consumers form their own opinion on the subject at hand. For example, when the target rate of inflation for the quarter or year is released, people will take this information and make an educated assumption of what they think the actual inflation rate will be. If their guess if different and others agree, it could shift the target rates (1). The question is, should these high-power economists or organizations consider their own opinion, the opinions of others, or both? After the financial crisis of 2008, central banks implemented a monetary policy called, “forward guidance (2).” Forward guidance is, “the practice of issuing carefully worded announcements about potential interest-rate changes, meant to encourage companies and consumers to spend money—and boost the economy. (2)” In an article from Chicago Booth Review, Alexander Richter said it is possible to stimulate the economy by manipulating consumers’ expectation. Therefore, people think they are changing target rates, but this was the plan all along. How are these target rates calculated though? Models like the Phillips curve help the Fed and central banks come up with a target rate that sustains price levels and employment. Janet Yellen argues that to understand the Phillips curve, it is best to understand behavioral economics (3). In conclusion, knowing popular opinion and consumer behavior can lead the Fed and central banks to make a more educated assumption of the future.

    1) https://files.stlouisfed.org/files/htdocs/publications/review/86/05/Central_May1986.pdf
    2) http://review.chicagobooth.edu/public-policy/2017/article/have-central-bankers-lost-their-power
    3) https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  25. Financial illiteracy in regards to monetary policy is interesting, and perhaps in our economy, we can break society into two groups – people who are financially literate and people who are not. People who are financially literate are people who are well educated and have a stake in knowing what certain terms mean and what the central bank is doing. For example, graduate students who participated in a financial literacy quiz were deemed financially literate (nytimes). Although, a higher score is preferred, the 65% is better than the 33% of people who took a financial literacy quiz and were a closer sample to the total population. It is clear that higher education plays a role in being financially literate, and a good reason for that could be the fact that college graduates, on average, earn a higher salary than people without degrees. For example, a person with his or her undergraduate degree earns $59,124 per year, with masters, $69,732 per year, and with a doctorates $84,396 per year – unemployment is never reaches below 3% for this demographic. Whereas, a person with a high school degree and non college is $35,256 per year, and person with some college but no degree is slightly higher at $38,376 per year – unemployment is 5% or higher (aol). Clearly, people who go to college and get a degree earn more on average per year. This means that consumers have more money to spend, and perhaps some invest on assets. Therefore, these people have an incentive to know what certain financial terms mean and how the fed may implement monetary policy.

    These things said, the fed has a role to play when it comes to people knowing what it is going to do and is encouraged to be as transparent as possible because a lot of investors base their actions on what they think the fed is going to do. However, it is also clear that only a small portion of investors are up to date on what the fed is doing – bankers and economists, mainly. The fed wants consumers to be financially literate because if they are not, they are a risk to our economy and could effect it by making stupid mistakes and causing another situation like the Great Recession – where people where taking out loans they were never going to be able to pay.

    Sources:
    https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html
    https://www.aol.com/article/finance/2017/03/01/the-average-salary-by-education-level/21864723/

  26. The Federal Reserve, under Janet Yellen, has started to take more behavioral economics into account when forming their monetary policy. They are using it to help increase the accuracy of their models and thus the effectiveness of their policy by better understanding consumer expectations and behavior. The Literature that Janet Yellen and John Williams discuss says that behavioral economics can and should be used to strengthen existing models, especially with respect to the underlying assumptions about consumers. Most consumers do not act in a perfectly rational way, but instead rely on their past experiences and heuristics to come to decisions. These cause systematic differences that can be accounted for by applying behavioral economics to existing models. Another factor that affects consumer decisions and expectations is the consumer’s knowledge. In the case of monetary policy this knowledge comes in the form of financial literacy. According to the many surveys in the Atlantic and Ny times articles, most Americans are not financially literate, especially minorities or those with only a high school level education. This can effect consumer expectations and should be taken into account when forming monetary policy by applying behavioral economic ideas.

    (1)https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/
    (2)https://www.frbsf.org/economic-research/publications/economic-letter/2014/june/financial-stability-monetary-policy/
    (3)https://www.theatlantic.com/business/archive/2016/05/financial-literacy/480807/
    (4)https://www.nytimes.com/2013/10/06/business/financial-literacy-beyond-the-classroom.html

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