Mental Accounting in a Business Cycle Model

Abstract

In standard business cycle models, consumers solve a dynamic optimization problem to decide how much to consume. This paper presents a new business cycle model in which consumers instead follow a simpler and more realistic decision process based on mental accounting. Consumers buy a good if the utility exceeds the pain of paying. A lower price and a bigger consumption budget decrease the pain of paying and thus increase consumer spending. Unlike standard models, consumers do not perfectly smooth their consumption and do not consider future prices and interest rates. The model addresses several puzzles: forward guidance is not overly powerful, negative supply shocks do not stimulate the economy, the equilibrium is unique and stable, and lower interest rates are not deflationary. Furthermore, a distinct implication is that liquid consumers can have a high marginal propensity to consume, consistent with the empirical evidence. As a result, a helicopter drop of money can effectively stimulate the economy, including at the zero lower bound.