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Bounded rationality in Keynesian beauty contests: A lesson for central bankers?

Felix Mauersberger, Rosemarie Nagel and Christoph Bühren

Economics - The Open-Access, Open-Assessment E-Journal (2007-2020), 2020, vol. 14, No 2020-16, 38 pages

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.

Keywords: Beauty Contest game; expectation formation; equilibration; level k reasoning; behavioral macroeconomics; game theory; experimental economics (search for similar items in EconPapers)
JEL-codes: C91 D80 D9 E12 E13 E7 (search for similar items in EconPapers)
Date: 2020
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http://dx.doi.org/10.5018/economics-ejournal.ja.2020-16
https://www.econstor.eu/bitstream/10419/219998/1/1701921766.pdf (application/pdf)

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Working Paper: Bounded rationality in Keynesian beauty contests: A lesson for central bankers? (2019) Downloads
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