The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Federal Reserve
Bank of Dallas
VOL. 13, NO. 7 • MAY 2018
Economic
Letter
Consumers Respond More
to Negative News than Positive Info
by Antonella Tutino
}
ABSTRACT: Consumers,
forced to navigate a
constant stream of economic
information, are often
challenged to sort through
details and respond to new
material. Experiments suggest
that people react more
forcefully to negative income
shocks than to positive ones.
Size also matters: Reaction to
small shocks is slower relative
to the response to big shocks.
C
oping with a seemingly constant
stream of breaking news is a particularly notable modern-day
challenge. The amount and frequency of
information about the economic environment may appear overwhelming, challenging one’s ability to process the implications
for personal finances and respond.
The laboratory provides insight into
how cognitively taxing it can become for
people exposed to changes in the economic landscape to acquire and process
information.
The laboratory corroborates an important theoretical point: Consumers react
asymmetrically to shocks to income, with
positive shocks generating a more muted
and delayed effect on spending than negative shocks. Also, individuals acknowledge
relatively small shocks with greater delay
than bigger ones. Small positive events
command less attention than small negative ones.
As a starting point to understanding this
phenomenon, assume that people have
limited attention to devote to news about
their environment, though they still want
to make rational consumption decisions.
Such an assumption translates into the
theoretical construct that sees people as
rationally inattentive.1
Rationally inattentive consumers are
people who have limited cognitive abil-
ity to process information about the
world around them. They react to news
slowly and imperfectly as a result of their
limitations.
For instance, suppose that Congress
proposes a tax reform bill that reduces
the tax burden on households. Given the
complexity of tax policy surrounding the
details and timing of implementation,
consumers may delay increasing their
consumption while they process additional information about how much the new
bill actually changes their budgets. As a
result, the fiscal stimulus that comes from
increased consumption spending might
not immediately occur.
Theoretical study has shown that consumers react asymmetrically to positive
and negative news about the economy.2
Specifically, people react faster and much
more strongly to negative shocks by lowering their consumption, while they delay
spending in response to positive shocks to
their finances.
In a lab experiment detailed here, test
subjects were asked to decide how much
they wanted to consume after processing
information about their income possibilities. Information about income is costly in
the sense that greater cognitive skills are
required to process more precise information. By choosing how much effort to
devote to processing information, people
Economic Letter
CHART
1
Simple Example of Cognitive Tasks
In the array below, what’s the missing shape?
Puzzle solution choices
ANSWER: Choice “C.”
rationally trade off precision of information
and consumption choices.
This asymmetry in the response of consumption to income shocks is novel in the
theoretical literature and has important
policy implications. When setting a path
for monetary policy, a gradual rise in the
Federal Reserve benchmark rate may be
less disruptive in terms of people’s decisions to save and the market’s reaction than
a steeper rate tightening. This result occurs
because gradual changes are absorbed
more slowly and trigger much smaller
behavioral responses than swift and sizable changes.
Experiment Design
The basis for the experiment showing this behavior is a theoretical model
2
where participants in each period choose
consumption after receiving a random
amount of income.3 There are no savings.
Each period starts with zero wealth and a
random draw of income from a uniform
distribution. The period begins with a draw
of income and ends with the selection of
consumption.
Participants do not know the amount
of the income draw, and they must decide
how much information they want about
their current income before consuming. To
obtain information about income, participants need to solve a task whose cognitive
difficulty is associated with the precision of
information. The more difficult the task, the
more precise the information.
In the experiment, the possible income
draws are contained in a range that arith-
metically can be viewed as residing within
the interval [1, 256]. Participants decide
how much information they want to
acquire by choosing among nine signals
whose difficulty levels range from trivial
(level zero), which provides no information, to the hardest (level eight), in which
the exact amount of income in each period
is revealed.
Suppose that for a given period, the
income is 55. The participant can sharpen
their knowledge of where in the interval
the income is located by selecting from
nine levels (or signals) of information,
with higher levels requiring completion of
increasingly difficult tasks.
A signal of type 0 simply indicates that
the amount of income is somewhere
between 1 and 256. A signal of type 1, if
the task is solved successfully, will tell
the participant the income is between 1
and 128—essentially cutting the range in
half. A signal of type 2, provided the task is
solved, will reveal that the actual income
is between 1 and 64, cutting the range by a
quarter, and so on.
The width of the interval is progressively
reduced toward the true income value as
the signal becomes more precise. The task
associated with a more precise signal is
more difficult.
Tasks are based on nonverbal puzzles
designed to measure cognitive ability. A
task is undertaken using a 3-by-3 table
of images arranged in a pattern, with the
image in the lower right corner removed
(Chart 1). In the example, the shape is the
same on each row but differs from row to
row.
Participants are given multiple possible
correct answers and must identify the correct one from the choices presented in the
Chart 1 puzzle solution. The correct answer
would be “c” because it has the right shape
and border.4 In this example, the puzzle is
of type 4 complexity. A less-difficult signal
would have only three figures to match up
with basic squares and no angles. A more
difficult type would feature more dimensions added to the task (number of objects,
shapes, angles, dimensions of the edges).
Upon successfully completing a task,
participants are shown the segment of the
partition of the income space where their
current income resides. The more difficult
the task selected, the smaller the segment
Economic Letter • Federal Reserve Bank of Dallas • May 2018
Economic Letter
(a more precise signal). Given the information acquired, participants select consumption for that period. If consumption exceeds
income, participants get zero consumption
for the period.
Once a consumption choice is made, the
participants have completed a period and
go on to the next one, where they start over
with a different income draw.
CHART
2
Consumption Response to Positive Income News Delayed, Muted
Unit of consumption, income
Bits of information
250
8
Average income (left axis)
Average consumption (left axis)
200
7
Average precision (right axis)
6
5
150
4
Asymmetric Response to News
Analysis of consumption choices by
participants reveals speed and precision
of consumption responses to changes in
income and the asymmetric responses to
negative and positive income news.
Consider news that is positive to income
(Chart 2). The chart illustrates the response
among all participants to an income
increase at time zero (green line) and the
corresponding change in consumption
(red line) and informativeness of the signal
acquired (blue line).
The chart shows that participants adjust
consumption in response to a positive
change in income while maintaining the
same cognitive effort toward processing
information. Consumption responses are
subdued with respect to income change,
reflecting that there is relatively little information regarding expansion of income possibilities. Participants raise their consumption gradually in response to good news on
their finances.
Now consider the aggregated responses
of participants to a negative income shock
of similar size to the positive one previously
presented (Chart 3).
Participants decrease their consumption
spending in response to negative news on
income in a way that is faster and sharper
than their response to positive news.
Even with shocks of similar size (in
absolute value, equal to about 80 percent
of expected income), the asymmetric
response of consumption to income innovation can be explained by the fact that if
attempted consumption exceeds income,
individuals end up consuming nothing in a
given period. Since acquiring more precise
information is cognitively costly, participants prefer to trade off choosing additional
consumption for avoiding expending more
effort in processing information.
This result matches evidence in the U.S.
economy regarding consumers’ propensity
100
3
2
50
1
0
-2
-1
0
1
2
0
3
Periods before, after shock ("0")
NOTES: Positive shock to income occurs at period 0, increasing income by about 75 units. Consumption and income units are
experimental dollars, with one unit of consumption/income corresponding to $0.75.
SOURCE: Author’s calculations.
CHART
Consumption Response to Negative Income News
3
Relatively Quick, Strong
Unit of consumption, income
Bits of information
250
Average income (left axis)
Average consumption (left axis)
200
8
7
Average precision (right axis)
6
5
150
4
100
3
2
50
1
0
-2
-1
0
1
2
3
0
Periods before, after shock ("0")
NOTES: Negative shock to income occurs at period 0, reducing income by about 50 units. Consumption and income units are
experimental dollars, with one unit of consumption/income corresponding to $0.75.
SOURCE: Author’s calculations.
to save additional income in the presence
of uncertainty.5
The experiment allows further investigation of the asymmetry as it relates not just
to the sign of the shock but also to the size.
For example, positive news of a 10 percent increase in expected income goes virtually unnoticed, failing to stimulate consumption (Chart 4).
This finding is particularly interesting
because it shows the limitations of fiscal and monetary policy when it seeks to
increase growth by stimulating consump-
tion spending. In an uncertain world
with abundant news about the economy,
stimulus can be ineffective simply because
people need time and cognitive resources
to properly assess how much a change in
the economic environment really affects
their pocketbooks.
Finally, this result matches the empirical
evidence revealed following the federal tax
rebate on consumption spending in 2001.
The rebate did not prompt U.S. households
to significantly increase spending, failing to
generate an anticipated economic boost.6
Economic Letter • Federal Reserve Bank of Dallas • May 2018
3
Economic Letter
CHART
Policy Implications
4
Lab experiments can usefully aid exploration of consumption responses to policy
changes affecting people’s wealth and
income. In particular, when individuals’
limitations processing information are taken into account, there is a failure to react
quickly and precisely to policy changes.
This lack of enthusiastic consumer
reaction may give pause when lawmakers contemplate the actual effects of fiscal stimulus to spur economic growth by
increasing consumer spending via tax law
change. More generally, the results point to
a limitation of fiscal and monetary policy to
translate into consumption and real activity
changes when people are hard-pressed to
fully process information about the anticipated changes.
Tutino is a senior economist in the Research Department at the Federal Reserve
Bank of Dallas.
Notes
See “Rationally Inattentive Consumption Choices,” by
Antonella Tutino, Review of Economic Dynamics, vol.16, no.
3, 2013, pp. 421–39.
1
See note 1.
2
Policy to Increase Income Modestly May Not Boost Consumption
Unit of consumption, income
250
Average income
Average consumption
200
150
100
50
0
-2
-1
0
1
2
3
Periods before, after shock ("0")
NOTES: Positive shock to income occurs at period 0, with income increasing by about 35 units. Consumption and income units
are experimental dollars, with one unit of consumption/income corresponding to $0.75.
SOURCE: Author’s calculations.
See note 1.
3
Option “a” is incorrect because the little triangles on the
border point in the wrong direction. Option “b” is incorrect
because it has the wrong shape. Option “d” is incorrect because the shape is the wrong shade. Option “e” is incorrect
because the shape is the wrong size. Option “f” is incorrect
because the shape is turned the wrong way. Option “g” is
incorrect because the border is not dashed. Option “f” is
incorrect because it is the wrong shade.
4
See “Myopia, Liquidity Constraints and Aggregate Consumption: A Simple Test,” by John Shea, Journal of Money,
Credit and Banking, vol. 27, no. 3, 1995, pp. 798–805.
5
See “Household Expenditure and the Income Tax Rebates
of 2001,” by Nicholas S. Souleles, Jonathan A. Parker and
David S. Johnson, American Economic Review, vol. 96, no.
5, 2006, pp. 1,589–610.
6
Federal Reserve Bank of Dallas
Economic Letter
Marc P. Giannoni, Senior Vice President and Director of Research
is published by the Federal Reserve Bank of Dallas. The views expressed are those of
the authors and should not be attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
Michael Weiss, Editor
Articles may be reprinted on the condition that the source is credited to the Federal
Reserve Bank of Dallas.
Economic Letter is available on the Dallas Fed website, www.dallasfed.org.
Jim Dolmas, Executive Editor
Dianne Tunnell, Associate Editor
Emily Rogers, Graphic Designer
Federal Reserve Bank of Dallas
2200 N. Pearl St., Dallas, TX 75201
@FedFRASER