“Psychological” elements in business cycle theories: old approaches and new insights

Abstract

This paper identifies a number of “psychological” elements in business cycle theories and shows how these components contribute to the theories’ results. It proceeds by discussing (i) which assumptions on behaviour were used, laying particular stress on expectations and confidence, money illusion, social preferences and interaction, and individual character traits; (ii) how they influenced and determined the theories’ results; and (iii) how more recent behavioural research provides a better and empirically grounded understanding of these factors. For each element, the possibility of incorporating new insights into older models is discussed, and references to work which already does so are given.

Keywords:

• Behavioural economics
• business cycle theory
• psychological elements

JEL Classifications:

• B12
• B13
• B22
• E32

Acknowledgements

This is a revised version of a paper originally prepared for and presented at the 15th Summer School on History of Economic Thought, Economic Philosophy and Economic History in Lille, France, on 3–8 September 2012. I am grateful to my discussants, Richard Arena and Dorian Jullien, for their insightful and very helpful remarks. I further thank Harald Hagemann and Johannes Schwarzer for their comments. Additionally, reviews by two anonymous referees were invaluable in honing the paper and stating its message more clearly. All errors remaining are entirely my own mistakes.

Notes

1 This is especially true for all the different “psychological” elements in Keynes's General Theory (1936). As Schmölders (1956, 12 f.) points out, those “psychological” remarks were primarily guided by subjective impressions and did not include standard contemporary psychological theory.

2 In the following description, Marshall is quoted with reference to book IV “Fluctuations of Industry, Trade and Credit” of Money, Credit and Commerce, but the relevant considerations on the usual course of fluctuations can already be found in Economics of Industry published more than 40 years earlier by Marshall and Marshall (1879).

3 This is especially true for two-generation models such as Azariadis and Guesnerie (1986), with the problem, however, that these models imply a cycle with a wavelength which far exceeds ordinary business cycles (see Chiappori and Guesnerie 1988, 396).

4 Similarly, Kurz (1994a, 1994b, 1996) constructs a model in which agents can calculate model-consistent forecasts for some variable moments, but not others, where subjective “rational beliefs” (the notion is not explicitly linked or related to Keynes's understanding of it) based on observed past data, which are necessarily consistent only for the individual and likely heterogeneous, are formed. These imply a larger set of possible economic outcomes and thus also fluctuations.

5 A far more extreme case, which is definitely not behavioural economics though, is Sargent's (1993) usage of “bounded rationality”, which has been rightly criticised for bearing hardly any resemblance to Herbert Simon's original understanding of the term (see Sent 1997).

6 See the next section for a critical discussion of this interpretation.

7 Even then, though, a closer look at Tobin's argument reveals that it is still incomplete: when only looking at relative positions, it is implausible that workers should on one side resist a nominal wage decrease, while settling with unchanged nominal wages in an inflationary environment – for in the latter setting, just as in the former, workers cannot know with certainty how wages in other firms or sectors develop. Therefore, if they forego nominal wage increases in an inflationary environment, they accept a deterioration of their relative position if workers elsewhere demand higher wages. Without referring to additional factors such as especially loss aversion or again money illusion (both of which are “psychological”), which would explain this very difference in perception, the argument therefore remains sketchy.

8 At around the same time, Oskar Morgenstern (1935) pointed at this idea, which later became part of The Theory of Games and Economic Behavior by John von Neumann and Morgenstern (1944).

9 The resulting theory of intertemporal choice based on Fisher's understanding of time preference appears to be more in line with the data than the life cycle (see Modigliani and Brumberg 1954) or Friedman's (1957) permanent income hypotheses, as Thaler (1997, 439) argues.

10 Even though Schumpeter might have opposed this label, a “psychological” factor (as in behaviour divergent from the usual neoclassical rationality standard) clearly lies at the heart of his theory.

11 In fact, this opens up a road not taken by Schumpeter himself, namely by taking a closer look at the behaviour of banks and “static” actors – both related to the propagation mechanism.