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. 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 quire sure what the central bank is doing? What is the difference if people do not know much about the financial world around them?

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

  1. Although the US economy is arguably the most powerful economy in the world, it’s a sad fact that most people don’t have a clue how interest rates or the Fed work. In his paper “Financial Innumeracy,” Phillip Hans Franses points out that only about 20% of consumers in a survey were able to correctly answer questions about interest rates, and that’s roughly the same statistic as guessing the answer. Similarly, people didn’t fully understand how long it takes to pay off a loan. (1) People who don’t understand how finance works only make it harder for the Fed to do its job. When people don’t understand markets, the panic following an intentional drop in interest rates (due to quantitative easing) makes the Fed’s actions counterproductive. People feel poor because they see the nominal values of their assets falling, so they don’t spend and banks don’t lend. (2) Lack of confidence in the economy keeps it from growing. This goes back to the idea that people think in nominal terms, so when wages and prices fluctuate, people buy and sell or mad to try to come out on top, when in real terms, it doesn’t make much of a difference in the long run.

    As Janet Yellen discussed in her speech about behavioral finance, people have an aversion to inflation. There’s a general sense that any inflation is bad, and it loses people elections. The Fed targets a specific level of inflation over time, and if people don’t understand the reasoning behind that, they’ll do everything they can to combat the nominal effects of rising prices. It seems that it would be more effective to not bother announcing what the Fed’s target rate for inflation is, and just conduct business behind closed doors. That way, the Fed’s actions can flow through to consumers without backlash against inflation when we need it. The other option is when the Fed announces its target and actions, they should also explain in detail the “how” and “why.” However, most people wouldn’t bother to try to understand what the Fed is trying to teach them. So the best solution is to just let the blind be blind and continue trying to guide the economy without panicking consumers making the job harder.

    (1) http://econpapers.repec.org/paper/emseureir/22234.htm
    (2) http://fortune.com/2012/12/11/why-quantitative-easing-isnt-working/

  2. There have been some recent implications that the Fed takes behavioral finance into making monetary policy. The Federal Reserve Governor Jerome Powell just recently came out after the end of the quantitative easing policy and said he’s “watching carefully for excesses in the financial markets due to the central bank’s near-zero interest rate policy.” He goes on to say that we are above full employment, and that inflation is low which show a “cautiously optimistic economy”. In his interview, he attempts to put trust in financial markets and increase consumer confidence. He repeatedly looks to the future and disregards and remarks of a possible bubble. Economist Robin Anderson also talked about the Fed’s use of behavioral finance. He says that Yellen is “…behind an idea of using explicit inflation and unemployment targets to inform the market about the Fed’s future plans (forward guidance).” This means that she is setting limits for inflation and unemployment that will lead to expectations of future monetary policy in which people can adjust their decisions to those possible future policies. This is also taking place with the European Central Bank. In a recent Wall Street Journal Article, writer Matthew Dalton shows that the ECB stimulus policy states that there is a “risk of outright deflation, in the sense of a broad-based and self-perpetuating fall in prices across the euro area…” This self-perpetuating deflation says that consumers will act different then the central bank expects them to following an increase in the supply of money. This will cause consumers to delay purchases in anticipation of even lower prices, rather than increasing spending which is what the central bank hoped for when increasing monetary policy.

    http://www.cnbc.com/id/102190887#.
    http://www.equities.com/editors-desk/investing-strategies/dividends-fixed-income/the-fed-s-secret-target
    http://blogs.wsj.com/briefly/2014/11/04/eu-cuts-its-eurozone-growth-forecast-the-short-answer/

  3. Behavioral economics, although a relatively new science, is one that the Federal Reserve Board should take into serious consideration while conducting monetary policy. Rational expectations make it easy to create economic theories, however it is simply not how real people always make decisions, therefore if there is a better way to predict aggregate demand decisions it should be explored deeply.

    According to the Richard H. Thaler and Sendhil Mullainathan, “The standard economic model of human behavior includes three unrealistic traits—unbounded rationality, unbounded willpower, and unbounded selfishness—all of which behavioral economics modifies” (1). Behavioral economics seeks to shrink the gap between the rational expectations model and the actuality of peoples’ decisions. Some people may act perfectly under these constraints, however a good amount of people would also like to believe they are making decisions that are not only good for them, but also good for society.

    The Federal Reserve has not been able to use behavioral economics to it’s full potential in the past due to the lack of models based on it. However, Chairwomen Yellen has shown that the impact of behavioral economics could be exponentially helpful to the Federal Reserve. She states,
    “In terms of the Federal Reserve’s public policy responsibilities, I can easily envision other ways in which explorations in behavioral economics could be of practical use. For example, one of the Federal Reserve’s responsibilities is to design consumer disclosures, including the information that borrowers receive from lenders when they take out a mortgage, apply for a credit card, or lease a new vehicle.”
    The Fed conducts monetary policy strongly based on what they believe consumers’ reactions will be to it. The application of behavioral economics may not be the perfect crystal ball for the Fed, but if it gets them closer predictions reactions then it will be extremely helpful.

    (1) http://www.econlib.org/library/Enc/BehavioralEconomics.html
    (2) http://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

  4. Irrational decision-making by consumers has encouraged the persistent emergence of behavioral economics, and ultimately led to the demise of the traditional economic concept, ‘homo economicus.’ To better evaluate consumer responses to monetary policy, the Federal Reserve has been factoring behavioral economic principals into their models. One facet of behavioral economics that has made its way into the Fed’s macroeconomic models is the idea that consumers form expectations about the future that effect their decisions today.

    As noted by Janet Yellen in a 2007 speech titled, Implications of Behavioral Economics for Monetary Policy, many behavioral economists theorize different explanations for how consumers shape their expectations. Some behavioral models, like those of Daniel Kahneman, assume people follow heuristics or rules of thumb when making decisions. One widely accepted heuristic that Kahneman observed in his research, relates to the availability of information a person has when making a decision. From his findings, Kahneman concluded that an individual’s decision-making might rely on the ease to which relevant information comes to mind. In general, most behavioral models adopt this idea that information can influence the public’s future expectations, but the explanation for how people digest the information varies. For example, one proposal is the “sticky information” approach by Mankiw and Reis (2002), which explains that agents do not take all information into account immediately. Another approach taken by Mackowiak and Wiederholt (2011), assumes decision makers have a limited amount of attention and choose how much information to acquire and process. Other behavioral models argue that when digesting information, individuals factor things such as fairness, envy, social status, and social norms into their decisions. The clear commonality across behavioral models is they seek to explain how expectations might be formed, and the resulting behavior that follows.

    Having the capability to better understand how consumers form expectations is a power the Fed would like to have in its arsenal. In an economy where the central bank conducts discretionary monetary policy, the most important tool the bank has above the rest is its credibility. Incorporating more behavioral principals into their macroeconomic models would allow the Fed to evaluate whether or not it has the power to shape expectations. If the Fed completely loses credibility, we might as well move to rule-based monetary policy because at this point any discretionary policy might be deemed ineffective.

    http://www.federalreserve.gov/boarddocs/Speeches/2003/20030203/default.htm
    http://www.federalreservehistory.org/Period/Essay/13
    http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=all&_r=1&

  5. A core concept to monetary policy is the belief in rational economic agents who use complete information to accurately assess changing nominal variables. Financial illiteracy and innumeracy both inhibits and guides monetary policy. Models used by the Federal Reserve behave similar to rational expectations, with some generalizations stating, “Participants in the economy behave so as to achieve the highest possible expected welfare and profits over time.” [1] While this is quite general, it does make a strong assumption supposing that every agent knows how to achieve these ends. A quiz of consumer’s knowledge by Philip Hans Franses showed that questions regarding interest rate computations were answered correctly in about 20% of the cases. [2] How can the Fed accurately impose inflation expectations into their models when trying to find the full employment output value of certain interest rates when consumers cannot accurately use interest rates in their own lives? While consumer’s ability to accurately use interest rates in their lives, large, real activity happens between few players in the market who have extensive knowledge. Therefore, the Fed should not concern themselves with the illiteracy of the “small fish.”
    However, considering that the laypeople of this country constitute a huge amount of consumption, the central bank’s main goal should be to provide stability in nominal and real values for an extended length of time. They should foster an environment of steady variables so as to allow adjustments to be made to individual and firm output. Giving consumers and producers time to adjust their levels of output in a “steady state” would allow the fed to then impose gradual miniscule changes in monetary policy which do not impede activity. If the central bank can sustain interest rates, liquidity, and inflation in a non-liquidity trap type scenario, then gradual implemented changes in the medium run will allow output to remain relatively stable through policy changes. The fed can then achieve their targets with minimal affects to aggregate demand.

    [1] http://www.federalreserve.gov/pubs/bulletin/1997/199704lead.pdf
    [2] http://econpapers.repec.org/paper/emseureir/22234.htm

  6. If the government truly wants to better the economy it needs to start by educating the population. Increasing the amount of financial literacy activities seems like the only solution to doing so. Currently the majority of the population doesn’t know how interest and inflation truly work or the difference in holding bonds vs company stock. This financial ignorance causes people to behave irrationally. People will mismanage their money leading to increased debt further increasing the income inequality. When conducting monetary or fiscal policy the true effects will be unknown because the majority of the population will not understand how prices, interest rates, or inflation works and affects them. By increasing the amount of financial literacy income inequality can be reduced and the FED will have a better idea of how the population will handle certain monetary policy. Currently workshops and classrooms are available to those who want to increase their financial literacy and be better at managing their personal finance. However, this seems like a small amount of effort put towards teaching people the underlying concepts of basic markets. To increase financial literacy nationally the government should require a new class to be taught in all public schools on how to manage personal finances. Economist Annamaria Lusardi and Olivia Mitchell have conducted studies on financial literacy around the world. They found that by providing financial knowledge to people with low levels of formal education on the subject lead to roughly an 82% increase in their initial wealth. Assuming people behave rationally with low financial literacy can’t be the case because obviously some of the population will not know how to manage their money. Since the majority of the population doesn’t know how to manage their money figuring out what the future effect of monetary policy will be impossible. So if financial literacy increases in the population monetary policy will now have a better known effect because how people will behave will be better known because more people will behave rationally. It’s time for the government to step in and reduce this financial illiteracy that is crippling new policies and income inequality, and help bring more wealth to the nation by education.
    http://www.theatlantic.com/international/archive/2014/05/the-danger-of-financial-ignorance-do-you-understand-money/361851/
    https://www.minneapolisfed.org/research/qr/qr421.pdf
    http://www.federalreserve.gov/publications/minority-women-inclusion/2012-financial-literacy.htm
    http://www.dailyfinance.com/2014/04/18/the-scary-state-of-financial-literacy-in-america/

  7. While monetary policy has been subject to many trends over the past decades, the standard model used by central banks is insufficient and a much more diverse approach based on insights from behavioral finance should be more widely examined. “Animal Spirits”, a notion introduced by J. M. Keynes, illustrates random periods of optimism and pessimism observed in investors and consumers, in regard to their decisions about consumption and investment. Research has provided numerous examples revealing that people oftentimes deviate from the way traditional theories assume. Individuals have money illusion, in addition to a number of outside influences including emotional, social, psychological, and cognitive factors that play a large role in influencing our decisions, causing us to behave in unpredictable or irrational ways.
    While behavioral economists typically agree with traditional ideas that markets are best understood by observing the behavior of individual agents and building from that, behavioralists also believe that the current model of human behavior models is too simplistic. The increasing amount of behavioral finance research can be attributed to the inability of traditional frameworks to explain recent empirical patterns across the world. By adding the component of behavioral finance research into policy making, the Fed has the potential to explain these patterns and strengthen the conceptual underpinnings of monetary policy.
    Behavioral finance is so important because it assists policymakers in understanding why individuals make the choices they do and in turn this research helps to improve the reliability of their economic models. Take the Phillip’s curve for example. This model has been around for decades and plays a critical role in policy determination, but with the inclusion of behavioral economics into this model, our understanding of the Phillips curve can be enhanced further. The New Keynesian Phillips Curve provides theoretical micro-foundations for a relationship between actual inflation and expected inflation one period in the future. This adjusted model has become an important tool for policy analysis. This is just one example of how behavioral finance can be used to enhance current central bank policy making.

    http://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/
    http://academicviews.qu.edu.az/en/articles/Monetary-Policy%3A-Psychology-and-Expectations-103.html
    http://www.bostonfed.org/economic/conf/BehavioralPolicy2007/
    http://bear.warrington.ufl.edu/ritter/publ_papers/Behavioral%20Finance.pdf

  8. The addition or at least recognition of behavioral finance in the implementation of monetary policy is a major step in the right direction. The assumption of all agents in the economy being rational is utopian in nature. Each individual may believe they are making rational decisions in their best interest but often times economists view of rational diverge from an average individuals view of rational.
    The success or failure of any monetary policy depends primarily on the ability of the policy makers to anticipate events and actions. Should the assumptions of rational behavior be incorrect, the policy maker’s ability to create effective monetary policy would be seriously hindered. The inclusion of behavioral finance may aid policy makers in predicting the future implications of certain policies. While behavioral finance does not command as much attention currently, emphasis on this field could bring about models that better predict agent’s behavior. With current extreme monetary policy not having the intended effects, Fed Chairperson Janet Yellen should give behavioral finance serious consideration.

    Bibliography

    https://research.stlouisfed.org/publications/review/85/05/Rational_May1985.pdf

    http://www.economics.utoronto.ca/jfloyd/modules/rxmp.html

  9. Though some may regard attempting to model behavioral economics as futile, others may argue that the potential benefit it offers could prove valuable. The Great Recession of the mid 2000s proved a shrewd example of the value behavioral economics offers. In the words of Paul Krugman, “during the golden years, financial economists came to believe that markets were inherently stable – indeed, that stocks and other assets were always priced just right.” Evaluation of solely concrete data cannot properly describe the economic climate and lacks perspective on all of the factors that may affect an economy. The Lucas critique highlights the fact that basing models on past consumer beliefs could prove irrelevant/wrong, though one could argue that just attempting to quantify consumer’s behavior is indeed better than no attempt at all. Behavioral economics may not be perfect but when consumer expectations play a major part in the direction of the economy, such as in the Lucas Islands model and the Expectations-augmented Phillips curve, an effort to model psychological motives of consumers can certainly offer some value. Understanding the greater convexity in the Philips Curve assumed in the latest additions to the New Keynesian Model allows the central bank to incorporate expectation effects on wages. Consumers do not have the amount of financial literacy that is assumed in the standard behavioral economics model and including greater volatility in the assumptions compensate for these differing behavioral effects. Many may not have a rational expectation of the relationship between inflation and output (as assumed), and could cause the marginal effects of increased inflation to be decreased and this should influence how central bankers attack the level of unemployment.

    http://www.ie.ufrj.br/hpp/intranet/pdfs/krugman_september_6_2009_howdideconomistsdidsowrong.pdf
    http://www.bostonfed.org/economic/conf/BehavioralPolicy2007/chapter2.pdf

  10. Though some may regard attempting to model behavioral economics as futile, others may argue that the potential benefit it offers could prove valuable. The Great Recession of the mid 2000s proved a shrewd example of the value behavioral economics offers. In the words of Paul Krugman, “during the golden years, financial economists came to believe that markets were inherently stable – indeed, that stocks and other assets were always priced just right.” Evaluation of solely concrete data cannot properly describe the economic climate and lacks perspective on all of the factors that may affect an economy. The Lucas critique highlights the fault in basing models on past consumer beliefs that could prove irrelevant, though one could argue that just attempting to quantify consumer’s behavior is indeed better than no attempt at all. Behavioral economics may not be perfect but when consumer expectations play a major part in the direction of the economy, such as in the Lucas Islands model and the Expectations-augmented Phillips curve, an effort to model psychological motives of consumers can certainly offer some value. Understanding the greater convexity in the Philips Curve assumed in the latest additions to the New Keynesian Model allows the central bank to incorporate expectation effects on wages. Consumers do not have the amount of financial literacy that is assumed in the standard behavioral economics model and including greater volatility in the assumptions compensate for these differing behavioral effects. Many may not have a rational expectation of the relationship between inflation and output (as assumed), and could cause the marginal effects of increased inflation to be decreased and this should influence how central bankers attack the level of unemployment.

    http://www.ie.ufrj.br/hpp/intranet/pdfs/krugman_september_6_2009_howdideconomistsdidsowrong.pdf

    http://www.bostonfed.org/economic/conf/BehavioralPolicy2007/chapter2.pdf

  11. Behavioral economics is the analysis of taking the psychological insights of a human’s behavior to explain their economic decision. Monetary policy puts emphasis on behavioral economics when implanting policy because the policy must manage expectations to be effective. To show this, most economic models assume rational expectations; however, if a majority of the public are ignorant in monetary policies and other aspects of the economy, is the central bank putting too much emphasis on something that doesn’t really have an impact?
    The central bank has started to “establish center[s] to promote and support research in behavioral economics” which is an important step in realizing the potential effects of expectations on policies, but it’s not enough. The Fed needs to begin to promote their policies and educate the public on their effects so that consumers will begin to act according to the new policies. Studies have shown that there is an idea that many people are “limited and bounded [to] their cognitive limitations and therefore, are inclined to use heuristics” in their decision making. This shows that consumers are not acting normally due to the simple fact that they do not know the implications of certain policies.
    Lastly, according to “animal spirits” by J.M. Keynes, consumers and investors go through waves of optimism and pessimism in regard to their decisions about output and investment. This runs parallel with the belief that consumers suffer from “money illusion”. They make decisions off returns from their investments rather than what can happen in the future based on monetary policy. This is similar to adaptive expectations where they base decisions off past periods.

    [1] http://academicviews.qu.edu.az/en/articles/Monetary-Policy%3A-Psychology-and-Expectations-103.html
    [2] http://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2007/september/implications-of-behavioral-economics-for-monetary-policy/

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