The paper, updated this month, by economist Xavier Gabaix of Harvard University, integrates behavioral economics findings into what’s known as a New Keynesian macroeconomic model—one that includes microeconomic decisionmaking and markets that aren’t perfectly competitive and that is the kind of model often used by central banks. The specific insight that Gabaix adds to the model is “bounded rationality,” where a person’s ability to make a decision is bounded by cognitive limits. One way to think of this is an individual who isn’t trying to make the best decisions but rather find the decision that is satisfactory. Part of these cognitive limits is that individuals or businesses will be myopic, or care a lot more about the present than the future. This is in contrast to perfectly rational agents who knows exactly how events in the future will impact them.
