Abstract
Abstract The great recession (2008) triggered an apparent discrepancy between empirical findings and macroeconomic models based on rational expectations alone. This gap led to a series of recent developments of a behavioral microfoundation of macroeconomics combined with the underlying experimental and behavioral Beauty Contest (BC) literature, which the authors review in this paper. They introduce the reader to variations of the Keynesian Beauty Contest (Keynes, The general theory of employment, interest, and money, 1936), theoretically and experimentally, demonstrating systematic patterns of out-of-equilibrium behavior. This divergence of (benchmark) solutions and bounded rationality observed in human behavior has been resolved through stepwise reasoning, the so-called level k, or cognitive hierarchy models. Furthermore, the authors show how the generalized BC function with limited parameter specifications encompasses relevant micro and macro models. Therefore, the stepwise reasoning models emerge naturally as building blocks for new behavioral macroeconomic theories to understand puzzles like the lacking rise of inflation after the financial crisis, the efficacy of quantitative easing, the forward guidance puzzle, and the effectiveness of temporary fiscal expansion.
Highlights
Markets like the stock market are prone to booms and crashes
We present a four-part structure: the first part is about the level-k model and how it describes out-of equilibrium behavior in a large set of experiments from over 25 years; the second section is about systematic patterns of out-of-equilibrium behavior in variations of Keynesian Beauty contest experiments which can be relevant in real-world situations or in behavioral macroeconomic models; third, we show how a generalized Beauty Contest (BC) function with limited parameter specifications encompasses relevant micro and macro models; fourth, we review new papers in macroeconomics applying the level k model to explain different macroeconomic puzzles
Since there have been many critiques of the Rational Expectations Equilibrium (REE) and since the evidence of level k as a heuristic of decision-making in the BC game is overwhelming, we argue that considering the implications of level k at the macroeconomic level is a logical step to open the box for out-of-equilibrium considerations in academic research
Summary
Markets like the stock market are prone to booms and crashes. Recent crashes have been the financial crisis 2008-2011 and the Corona crisis in early 2020. In response to the increasing use of non-rational expectations in economics, macroeconomic papers such as Woodford (2013) and Garcıa-Schmidt and Woodford (2019) make use of the notion of temporary equilibrium By temporary equilibrium they mean that market outcomes at any point in time result from optimizing decisions by households and firms but that their expectations need not be correct. By changing the parameter from positive (e.g., 2/3) to negative values (e.g., -2/3), we can discuss the difference between positive (e.g., the higher others’ choices, the higher my choice) and negative feedback (e.g., the higher other players’ choices the lower my choice) situations which have very different convergence patterns This kind of heterogeneity in behavior and beliefs of different players has led to the so-called level k (Nagel, 1995), and some variations (Stahl and Wilson, 1995), or the cognitive hierarchy model (Camerer et al, 2004).
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