Unlike in standard models, decision makers often narrowly bracket and make each decision in isolation. I develop a new approach, which I term narrow thinking, to systematically model narrow bracketing. The definition of narrow thinking is that different decisions are based on different, non-nested, information. As a result, the narrow thinker makes each decision with imperfect knowledge of other decisions and faces difficulties coordinating her multiple decisions. The narrow thinker effectively cares less about her other decisions when making each decision. The main application of narrow thinking is to provide a smooth model of mental accounting without requiring the decision maker to have explicit budgets. My approach generates unique predictions about how the degree of mental accounting depends on expenditure shares and cognitive limitations. It also illustrates how narrow bracketing and mental accounting can be explained by the same underlying friction.

We revisit the question of why shifts in aggregate demand drive business cycles. Our theory combines intertemporal substitution in production with rational confusion, or bounded rationality, in consumption and investment. The first element allows aggregate supply to respond to shifts in aggregate demand without nominal rigidity. The second introduces a “confidence multiplier,” that is, a positive feedback loop between real economic activity, consumer expectations of permanent income, and investor expectations of returns. This mechanism amplifies the business-cycle fluctuations triggered by demand shocks (but not necessarily those triggered by supply shocks); it helps investment to comove with consumption; and it allows front-loaded fiscal stimuli to crowd in private spending.

How does the economy respond to news about future policies or future fundamentals? Standard practice assumes that agents have common knowledge of such news and face no uncertainty about how others will respond. Relaxing this assumption attenuates the general equilibrium effects of news and rationalizes a form of myopia at the aggregate level. We establish these insights within a class of games which nests, but is not limited to, the New Keynesian model. Our results help resolve the forward-guidance puzzle, offer a rationale for the front-loading of fiscal stimuli, and illustrate more broadly the fragility of predictions that rest on long series of forward-looking feedback loops. (JEL D82, D83, D84, E12, E23, E52, E62)

Our understanding of monetary policy is complicated by an indeterminacy problem: the same path for the nominal interest rate is consistent with multiple equilibrium paths for inflation and output. We offer a potential resolution by showing that small frictions in social memory and intertemporal coordination can remove this indeterminacy. Under our perturbations, the unique equilibrium is the same as that selected by the Taylor principle, but it no more relies on it; monetary policy is left to play only a stabilization role; and fiscal policy needs to be Ricardian even when monetary policy is passive.

Macro-finance analyses commonly link firms’ borrowing constraints to the liquidation value of physical assets. For U.S. nonfinancial firms, we show that 20% of debt by value is based on such assets (asset-based lending in creditor parlance), whereas 80% is based predominantly on cash flows from firms’ operations (cash flow–based lending). A standard borrowing constraint restricts total debt as a function of cash flows measured using operating earnings (earnings-based borrowing constraints). These features shape firm outcomes on the margin: first, cash flows in the form of operating earnings can directly relax borrowing constraints; second, firms are less vulnerable to collateral damage from asset price declines, and fire sale amplification may be mitigated. Taken together, our findings point to new venues for modeling firms’ borrowing constraints in macro-finance studies.

We ask how fiscal deficits are financed in environments with two key features: (i) nominal rigidity, and (ii) a violation of Ricardian equivalence due to finite lives or liquidity constraints. In such environments, deficits can contribute to their own financing through two channels: a boom in real economic activity, which expands the tax base; and a surge in inflation, which erodes the real value of nominal government debt. Our main theoretical result establishes that this mechanism becomes more potent as fiscal adjustment is delayed, leading to full self‐financing in the limit: if the monetary authority does not lean too heavily against the fiscal stimulus, then the government can run a deficit today, refrain from tax hikes or spending cuts in the future, and still see its debt converge back to its initial level. We further demonstrate that a significant degree of self‐financing is achievable when the theory is disciplined by empirical evidence on marginal propensities to consume, nominal rigidities, the monetary policy reaction, and the speed of fiscal adjustment.

How do low interest rates affect investor behavior? We demonstrate that individuals “reach for yield, ” that is, have a greater appetite for risk-taking when interest rates are low. Using randomized investment experiments holding fixed risk premiums and risks, we show low interest rates lead to significantly higher allocations to risky assets among diverse populations. The behavior is not easily explained by conventional portfolio choice theory or institutional frictions. We then propose and provide evidence of mechanisms related to investor psychology, including reference dependence and salience. We also present results using observational data on household investment decisions. Received July 18, 2017; editorial decision July 30, 2018 by Editor Andrew Karolyi.

We study how people’s beliefs about the economy covary with household-level events, utilizing a unique link between Danish administrative data and a large-scale survey of consumer expectations. We find that compared to actual inflation, people’s inflation forecasts covary much more strongly (and negatively) with both recently realized household income changes and measures of expected future household income changes. We formally establish that these findings are stark deviations from the Bayesian rational expectations benchmark. Similar results hold for perceptions of past inflation (“backcasts” ), suggesting that imperfect recall is a key mechanism for biased forecasts. Building on this, a series of additional tests, some of which utilize data on adverse health events, suggests that the forecast biases are at least partly due to affect-cued recall. That is, negative (positive) household-level events cue negative (positive) recollections, which lead to pessimistic (optimistic) forecasts.

We study the psychological costs of financial constraints and their economic consequences. Using a representative survey of U.S. households, we document the prevalence of financial stress in U.S. households and a strong relationship between financial stress and measures of financial constraints. We incorporate financial stress into an otherwise standard dynamic model of consumption and labour supply. We emphasize two key results. First, both financial stress itself and naivete about financial stress are important components of a psychology-based theory of the poverty trap. Sophisticated households, instead, save extra to escape high-stress states because they understand that doing so alleviates the economic consequences of financial stress. Second, the financial stress channel dampens or reverses the counterfactual large negative wealth effect on labour earnings because relieving stress frees up cognitive resources for productive work. Financial stress also has macroeconomic implications for wealth inequality and fiscal multipliers.