1. New Directions for IPE: Drawing from Behavioral Economics Deborah Elms IPES Conference November 2006

2. Equity Premium Puzzle Why do people simultaneously hold stocks and bonds? Puzzle: given low yield on bonds and standard risk calculations, no one should hold both Unable to explain 6% difference in return Puzzle holds from 1802-1990 Even concerns over stock market crash insufficient to account for pattern

3. Solution: Myopic Loss Aversion Two key elements for Thaler et. al. Mental accounting Loss aversion Under mental accounting Evaluate stocks and bonds separately Viewed at various time intervals (esp. one year) Loss aversion Short-term losses in stocks felt keenly Reinforced the more often reevaluation takes place

4. Reevaluate Ken Scheve’s IO Article Do macroeconomic priorities of citizens differ across countries? Answer—yes, especially with focus on inflation and unemployment National-level variables account for most of difference Inflation aversion and “acceptable” unemployment levels not stable across countries No convergence on “ideal” policy

5. But Add in Myopic Loss Aversion Should prefer greater unemployment and less inflation under high inflation If myopic loss aversion happening, key issue is not “what is current level of inflation?” but “is level of inflation rapidly rising or falling?” If inflation is high but unchanged, less public demand for broad policy changes The more often public gets information about levels, more volatile reactions become Election season critical

6. Historical Experience Matters History important in setting baseline expectations of public over inflation/unemployment More information leads to more reevaluation of status quo and changes from status quo Under loss, accept more risk Optimal policy response impossible to achieve across multiple states Design of monetary institutions will vary across states

7. Review of Paper Why has IPE not incorporated insights of behavioral economics? Normative role of baseline expectations, methodological concerns, and lack of knowledge Role of losses Why do regulators opt for harmonization? Twin shocks drive perception of losses Fairness What drives state behavior in GATT/WTO negotiations? Law, power and fairness considerations