I develop a behavioral macroeconomic model in which agents have cognitive limitations. As a result, they use simple but biased rules (heuristics) to forecast future output and inflation. Although the rules are biased, agents learn from their mistakes in an adaptive way. This model produces endogenous waves of optimism and pessimism (“animal spirits”) that are generated by the correlation of biased beliefs. I identify the conditions under which animal spirits arise. I contrast the dynamics of this model with a stylized DSGE-version of the model and I study the implications for monetary policies. I find that strict inflation targeting is suboptimal because it gives more scope for waves of optimism and pessimism to emerge thereby destabilizing output and inflation.

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Animal spirits and monetary policy

An air-sea interaction theory for tropical cyclones [presentation]

I distinguish two types of macroeconomic models. The first type are top-down models in which some or all agents are capable of understanding the whole picture and use this superior information to determine their optimal plans. The second type are bottom-up models in which all agents experience cognitive limitations. As a result, these agents are only capable of understanding and using small bits of information. These are models in which agents use simple rules of behavior. These models are not devoid of rationality. Agents in these models behave rationally in that they are willing to learn from their mistakes. These two types of models produce a radically different macroeconomic dynamics. These differences are analyzed in this article.

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Top-down versus bottom-up macroeconomics

DSGE-models provide a coherent framework of analysis. This coherence is brought about by restricting acceptable behavior of agents to dynamic utility maximization and rational expectations. The problem of the DSGE-models (and more generally of macroeconomic models based on rational expectations) is that they assume extraordinary cognitive capabilities of individual agents. In addition, these models need a lot of ad-hoc assumptions to make them fit the data. I argue that we need models that take into account the limited cognitive abilities of agents. One can introduce rationality in such models by assuming “trial and error“ learning. I propose such a model and I analyze its implications.

The scientific foundation of dynamic stochastic general equilibrium (DSGE) models

In mainstream economics, and particularly in New Keynesian macroeconomics, the booms and busts that characterize capitalism arise because of large external shocks. The combination of these shocks and the slow adjustments of wages and prices by rational agents leads to cyclical movements. In this book, Paul De Grauwe argues for a different macroeconomics model--one that works with an internal explanation of the business cycle and factors in agents' limited cognitive abilities. By creating a behavioral model that is not dependent on the prevailing concept of rationality, De Grauwe is better able to explain the fluctuations of economic activity that are an endemic feature of market economies. This new approach illustrates a richer macroeconomic dynamic that provides for a better understanding of fluctuations in output and inflation.

	De Grauwe shows that the behavioral model is driven by self-fulfilling waves of optimism and pessimism, or animal spirits. Booms and busts in economic activity are therefore natural outcomes of a behavioral model. The author uses this to analyze central issues in monetary policies, such as output stabilization, before extending his investigation into asset markets and more sophisticated forecasting rules. He also examines how well the theoretical predictions of the behavioral model perform when confronted with empirical data.

	
		Develops a behavioral macroeconomic model that assumes agents have limited cognitive abilities
	
		Shows how booms and busts are characteristic of market economies
	
		Explores the larger role of the central bank in the behavioral model
	
		Examines the destabilizing aspects of asset markets

Lectures on Behavioral Macroeconomics

The effect of stationary cylindrical rods located at the centerline axis on the vortex breakdown (VB) in a closed flow is studied experimentally and numerically. The flow takes place in a cylindrical container with a rotating end wall. The dimensionless numbers characterizing the dynamics of the system are the Reynolds number, based on the angular velocity of the rotating wall, the aspect ratio of the container and dimensionless radius of the rod. We find that the onset of VB, as a function of the Reynolds number, is anticipated for very small values of the rod radius R r , while it is delayed for values of R r beyond a critical value. In order to characterize this effect, the critical Reynolds number for the appearance of the vortex breakdown as a function of the radius of the stationary rods and the different aspect ratios was accurately determined, using digital particle image velocimetry and numerically using a three-dimensional Navier–Stokes solver. The numerical and experimental results are compared showing an excellent agreement.

Influence of coaxial cylinders on the vortex breakdown in a closed flow

We provide a simple theory of inflation inertia in a staggered price setting framework a la Calvo (1983). Contrary to Calvo's formulation, the frequency of price changes is allowed to vary according to an evolutionary criterion. Inertia is the direct result of gradual adjustment in this frequency following a permanent change in the rate of money growth. (JEL: E31)

/pdf/an-evolutionary-theory-of-inflation-inertia-23dej1mcjg.pdf

An Evolutionary Theory of Inflation Inertia

We study the thermodynamics of the water rocket in the thrust phase, taking into account the expansion of the air with water vapor, vapor condensation and the energy taken from the environment. We set up a simple experimental device with a stationary bottle and verified that the gas expansion in the bottle is well approximated by a polytropic process $PV^\beta$= constant, where the parameter $\beta$ depends on the initial conditions. We find an analytical expression for $\beta $ that only depends on the thermodynamic initial conditions and is in good agreement with the experimental results.

Air expansion in the water rocket

Two-layer stratified flows over abrupt topographic obstacles, simulating relevant situations in oceanographic problems, are investigated numerically and experimentally in a simplified two-dimensional situation. Experimental results and numerical simulations are presented at low-to-intermediate Froude numbers for two different obstacles: one semicylindrical and the other prismatic. In both cases, four different flow regimes downstream of the obstacles are found: (I) subcritical flow, (II) internal hydraulic jump, (III) Kelvin–Helmholtz instability at the interface, and (IV) shedding of billows. The critical values of the Froude number for the transition between different regimes depend strongly on the shape of the obstacle. In regime (III), we show that the characteristics of the lee wave that appears past the obstacle can be explained with a theoretical stability analysis. Almost independence of the vortex shedding frequency with upstream velocity is observed and explained.

Two-layer stratified flows over pronounced obstacles at low-to-intermediate Froude numbers

We study the thermodynamics of a water rocket in the thrust phase, taking into account the expansion of the air with water vapor, vapor condensation, and the corresponding latent heat. We set up a simple experimental device with a stationary bottle and verify that the gas expansion in the bottle is well approximated by a polytropic process PVβ = constant, where the parameter β depends on the initial conditions. We find an analytical expression for β that depends only on the thermodynamic initial conditions and is in good agreement with the experimental results.

Italo Bove

Papers

Influence of coaxial cylinders on the vortex breakdown in a closed flow

An Evolutionary Theory of Inflation Inertia

Air expansion in the water rocket

Two-layer stratified flows over pronounced obstacles at low-to-intermediate Froude numbers

Air expansion in a water rocket