Consumption and Fluctuations: What Role for Behavioral Economics?

A role is proposed for Behavioral Economics in the economic cycle, and it is empirically tested. In particular, we argue that the use of spending heuristics plays a role in amplifying fluctuations. Empirical analysis indicates that, by far, the most robust determinant of consumption is current income (in rates), especially in less developed economies, a result consistent with the Mental Accounting hypothesis. Additionally, high volatility environments are associated with a more pronounced mental rule, linked to the need to exercise what we call Cognitive Closure in these contexts. The analysis of on- and off-trend consumption indicates: (i) marginal propensities to consume (MPCs) are positive and significant both on- and off-trend; (ii) in developed countries MPCs increase appreciably during accelerated expansions; and (iii) in developing countries MPCs remains roughly constant on- and off-trend. These results suggest a role for traditional countercyclical policy.