Saturday, November 26, 2011

Most Of The Time We Are Not Rational And That's OK

One of the founders of behavioral economics tells us that we have two modes of thought. Our most commonly used mode of thought is intuitive. Its far from rational but it is good enough for most of the decisions that we make. Fortunately we are not aware of how little we know when we make decisions. If we knew how little we knew, we would not be able to act as optimistically as we do. This line of reasoning flies in the face of economic theories that assume rationality. One of the conclusions of rational expectations theory is that individuals can predict the consequences of government policies far into the future. For example, if the government runs large budget deficits to stimulate the economy, individuals will conclude that taxes will increase in the future. In order to pay for future taxes they will save more of their income. By increasing their savings, and cutting their current spending, rational individuals will negate the effect of the government's effort to stimulate the economy by running deficits. Its not surprising that economic theories which assume rationality have such weak predictive power. On the other hand, it would be difficult to develop mathematical models of economic behavior if we assumed that many of our economic decisions were made intuitively.

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