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?