In 1974 an article appeared in Science magazine with the dry-sounding title “Judgment Under Uncertainty: Heuristics and Biases” by a pair of psychologists who were not well known outside their discipline of decision theory. In it Amos Tversky and Daniel Kahneman introduced the world to Prospect Theory, which mapped out how humans actually behave when faced with decisions about gains and losses, in contrast to how economists assumed that people behave. Prospect Theory turned Economics on its head by demonstrating through a series of ingenious experiments that people are much more concerned with losses than they are with gains, and that framing a choice from one perspective or the other will result in decisions that are exactly the opposite of each other, even if the outcomes are monetarily the same. Prospect Theory led cognitive psychology in a new direction that began to uncover other human biases in thinking that are probably not learned but are part of our brain’s wiring.

Thinking fast and slow.

In this book, Andrew Harvey sets out to provide a unified and comprehensive theory of structural time series models. Unlike the traditional ARIMA models, structural time series models consist explicitly of unobserved components, such as trends and seasonals, which have a direct interpretation. As a result the model selection methodology associated with structural models is much closer to econometric methodology. The link with econometrics is made even closer by the natural way in which the models can be extended to include explanatory variables and to cope with multivariate time series. From the technical point of view, state space models and the Kalman filter play a key role in the statistical treatment of structural time series models. The book includes a detailed treatment of the Kalman filter. This technique was originally developed in control engineering, but is becoming increasingly important in fields such as economics and operations research. This book is concerned primarily with modelling economic and social time series, and with addressing the special problems which the treatment of such series poses. The properties of the models and the methodological techniques used to select them are illustrated with various applications. These range from the modellling of trends and cycles in US macroeconomic time series to to an evaluation of the effects of seat belt legislation in the UK.

Forecasting, Structural Time Series Models and the Kalman Filter

The theory of precautionary saving is shown in this paper to be isomorphic to the Arrow-Pratt theory of risk aversion, making possible the application of a large body of knowledge about risk aversion to precautionary saving, and more generally, to the theory of optimal choice under risk In particular, a measure of the strength of precautionary saving motive analogous to the Arrow-Pratt measure of risk aversion is used to establish a number of new propositions about precautionary saving, and to give a new interpretation of the Oreze-Modigliani substitution effect

Precautionary Saving in the Small and in the Large

We investigate whether differences in individuals’ experiences of macro-economic shocks affect longterm risk attitudes, as is often suggested for the generation that experienced the Great Depression. Using data from the Survey of Consumer Finances from 1964-2004, we find that birth-cohorts that have experienced high stock market returns throughout their life report lower risk aversion, are more likely to be stock market participants, and, if they participate, invest a higher fraction of liquid wealth in stocks. We also find that cohorts that have experience high inflation are less likely to hold bonds. These results are estimated controlling for age, year effects, and a broad set of household characteristics. Our estimates indicate that stock market returns and inflation early in life affect risk-taking several decades later. However, more recent returns have a stronger effect, which fades away slowly as time progresses. Thus, the experience of risky asset payoffs over the course of an individuals’ life affects subsequent risk-taking. Our results explain, for example, the relatively low rates of stock market participation among young households in the early 1980s (following the disappointing stock market returns in the 1970s depression) and the relatively high participation rates of young investors in the late 1990s (following the boom years in the 1990s).

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Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?*

A large output gap accompanied by stable inflation close to its target calls for further monetary accommodation, but the zero lower bound on interest rates has robbed the Federal Open Market Committee (FOMC) of the usual tool for its provision. We examine how public statements of FOMC intentions—forward guidance—can substitute for lower rates at the zero bound. We distinguish between Odyssean forward guidance, which publicly commits the FOMC to a future action, and Delphic forward guidance, which merely forecasts macroeconomic performance and likely monetary policy actions. Others have shown how forward guidance that commits the central bank to keeping rates at zero for longer than conditions would otherwise warrant can provide monetary easing, if the public trusts it. We empirically characterize the responses of asset prices and private macroeconomic forecasts to FOMC forward guidance, both before and since the recent financial crisis. Our results show that the FOMC has extensive experience successfully telegraphing its intended adjustments to evolving conditions, so communication difficulties do not present an insurmountable barrier to Odyssean forward guidance. Using an estimated dynamic stochastic general equilibrium model, we investigate how pairing such guidance with bright-line rules for launching rate increases can mitigate risks to the Federal Reserve’s price stability mandate.

https://chicagofed.org/~/media/publications/working-papers/2012/wp2012-03-pdf.pdf

Macroeconomic Effects of Federal Reserve Forward Guidance

This paper examines precautionary behavior by relating job-loss risk to household net worth. We use existing best practice and some new strategies to deal with some problematic issues inherent in this literature regarding proxying uncertainty, instrumentation, and incorporating theoretical restrictions. We do not find precautionary variation in the wealth holdings of households with low permanent income, but do find precautionary effects for moderate and higher-income households. When the dependent variable is total net worth, these findings are robust to several alternative specifications. But we do not find precautionary responses in subaggregates of wealth that exclude home equity.

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Unemployment Risk and Precautionary Wealth: Evidence from Households' Balance Sheets

With projections showing inflation heading back toward target and the labor market continuing to improve, the Federal Reserve has begun to contemplate an increase in the federal funds rate. There is, however, substantial uncertainty around these projections. How should this uncertainty affect monetary policy? In many standard models uncertainty has no effect. In this paper, we demonstrate that the zero lower bound (ZLB) on nominal interest rates implies that the central bank should adopt a looser policy when there is uncertainty. In the current context this result implies that a delayed liftoff is optimal. We demonstrate this result theoretically through two canonical macroeconomic models. Using numerical simulations of our models calibrated to the current environment, we find that optimal policy calls for a delay in liftoff of two to three quarters relative to a policy that does not take into account uncertainty about policy being constrained by the ZLB. We then use a narrative study of Federal Reserve communications and estimated policy reaction functions to show that risk management is a long-standing practice in the conduct of monetary policy.

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Risk Management for Monetary Policy Near the Zero Lower Bound

Using data from the Federal Reserve Board's Survey of Consumer Finances, the authors examine characteristics of entrepreneurs and the businesses they run. Their analysis confirms that business owners are important sources of saving and wealth creation in the U.S. and that they are less risk averse than other wealthy households. This discounts the notion that the wealth of entrepreneurs disproportionately reflects a buildup of precautionary balances to guard against financial risk.

Evidence on Entrepreneurs in the United States: Data from the 1989-2004 Survey of Consumer Finances

Introduction and summary A country’s national saving rate is a crucial determinant of its ability to accumulate capital and generate growth; hence, it is an important determinant of the country’s future prosperity. Another important determinant of a country’s prosperity is innovation—the ability to generate new goods and services and provide existing ones in a more efficient manner. Accordingly, it is vital to study the households that are savers, as well as the managers of the businesses that are innovators. In this article, we consider the behavior of a group of individuals who play both roles in the U.S. economy— entrepreneurs. First, entrepreneurs accumulate capital. As noted by Quadrini (1999, 2000), on average, entrepreneurs save a good deal more than other households: Even though households headed by entrepreneurs make up only 7–8 percent of the population, they own nearly one-third of the wealth in the United States. Second, entrepreneurial risk-taking is thought to be an important way that individuals with skills, ideas, and business savvy introduce new products, technologies, and business strategies into the economy. This is the entrepreneur described by economists such as Schumpeter (1934) and Knight (1921). Such individuals are willing to put their financial well-being on the line in risky business ventures, with the expectation of earning large returns and expanding their wealth. A third important feature of entrepreneurship is that the business owner’s personal skills and financial resources are much more closely linked to the operations and performance of the firm than is the case with owners of widely held publicly traded corporations. Most shareholders of public firms have little say in the management of the business; and because their risk exposure is limited to the value of their shares, their personal portfolios are irrelevant to the assessment of the firm’s creditworthiness. In contrast, entrepreneurs’ relationships with their businesses are anything but at arm’s length. As managers, they make all of the dayto-day decisions about the firms’ operations. As owners, they reap most of the rewards of success, but in many cases, their personal assets help finance the business and are at risk if the business fails. This means that there is a fundamental and bi-directional link between entrepreneurial households’ portfolios and the performance of their businesses. In this article, we present a number of stylized facts that can help us understand the roles that entrepreneurs play in the U.S. economy. First, we construct an empirical counterpart to Schumpeter and Knight’s notion of the entrepreneur in the context of the information collected by the Federal Reserve Board’s Survey of Consumer Finances (SCF). Second, we use the SCF data to document a number of facts about entrepreneurs and the businesses that they run. We show that entrepreneurs, as a group, are very rich. They account for about 30 percent of the households in the top decile of the wealth distribution in the United States. They also earn more income than others, though the disparity is not as great as it is for wealth. They hold about as much total net wealth relative to their income as other rich people. Entrepreneurs also fall into two demographic categories that have more wealth than the population as a whole; that is, they are more educated and less likely to be a minority than the general population. Looking at their businesses, we see entrepreneurs operating in

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Evidence on entrepreneurs in the United States: Data from the 1989-2004 Survey of Consumer Finances

This paper examines how the professional forecasters comprising the Blue Chip Economic Consensus view shocks to GDP I use an unobserved components model of the forecast revisions to identify forecasters ' perceptions of permanent and transitory shocks to GDP The model indicates forecasters: attribute about two-thirds of the variance in current-period revisions to permanent shocks; view the relative importance of permanent shocks similar to the estimates of some simple univariate econometric models; see high-frequency indicators of economic activity as being informative about both permanent and transitory shocks; and react to incoming data differently during periods of economic weakness (JEL C51, C53, E23, E27, E32, E37) activity depends crucially not only on the actual source of the shocks to the economy, but also on agents' real-time perceptions of the nature of these shocks The behavior of households and businesses will depend on the degree to which they believe the economy is experiencing a permanent shift in productive capacity, as opposed to a transitory fluctuation about trend For example, regardless of its ultimate persistence, a fluctuation in labor income that is perceived to be permanent will have a larger immediate impact on consumption and overall economic activity than one that is thought to be transitory So, understanding agents' perceptions of the permanence of shocks is informative both for the historical interpretation of business cycles and for realistic modeling of expectational structures There is a long history of empirical studies that estimate the permanent and transitory components of actual gross domestic product (GDP);1 and today the economic and statistical identification of these shocks are standard features of most business

Spencer D. Krane

Papers

Unemployment Risk and Precautionary Wealth: Evidence from Households' Balance Sheets

Risk Management for Monetary Policy Near the Zero Lower Bound

Evidence on Entrepreneurs in the United States: Data from the 1989-2004 Survey of Consumer Finances

Evidence on entrepreneurs in the United States: Data from the 1989-2004 Survey of Consumer Finances

Professional Forecasters' View of Permanent and Transitory Shocks to GDP