Mental Accounting in a Business Cycle Model

Abstract

Motivated by the consumer behavior literature, this paper presents a new business cycle model in which consumers incur a pain of paying and neglect the opportunity costs of consumption. Although consumers maximize their utility and have perfect foresight, the model does not have an Euler equation. As a result, the marginal propensity to consume of liquid consumers can be high, in line with the empirical evidence. Furthermore, several puzzles disappear: forward guidance is not overly powerful, negative supply shocks do not stimulate the economy, lower interest rates are not deflationary, and the equilibrium is unique. Finally, the model is tractable and can be easily solved in closed form.