What Are the Human Behaviors Economists Should Observe When Creating Economic Models?

Economic models aim to predict how people and markets behave, but they are only as accurate as their assumptions. Human behavior is complex and often irrational, requiring economists to carefully consider behavioral patterns when designing models. Ignoring real-world decision-making leads to flawed predictions and ineffective policies.

To improve accuracy, economists must examine specific behaviors that shape financial choices and market trends.

Spending Patterns

Consumer spending drives economic activity, influencing business revenues and government tax collections. Economists analyze how individuals allocate income across necessities, discretionary goods, and luxury items, as shifts in these categories signal broader trends. Increased spending on non-essential goods like electronics and travel reflects consumer confidence, while a rise in grocery and utility expenditures without higher wages may indicate financial strain.

Inflation, income levels, and access to credit shape purchasing decisions. When inflation erodes purchasing power, consumers prioritize essentials, reducing demand for high-margin products like new cars or designer clothing. Interest rate changes also affect borrowing costs, influencing large purchases such as homes and vehicles. The Federal Reserve’s rate hikes in 2022 and 2023, for instance, slowed mortgage applications as higher borrowing costs made homeownership less accessible.

Seasonal trends also impact spending. Retail sales surge during the holiday season, with November and December accounting for a significant share of annual revenue for many businesses. Back-to-school shopping in late summer drives demand for clothing, electronics, and school supplies. Understanding these patterns helps businesses and policymakers anticipate economic fluctuations and adjust strategies accordingly.

Saving Behavior

Saving habits influence economic stability, investment flows, and long-term financial security. The amount individuals save depends on income levels, cultural attitudes, and expectations about the future. In countries with strong social safety nets, people may save less, while in economies with limited government support, individuals often prioritize financial reserves. The U.S. personal savings rate fluctuates based on economic conditions, rising during uncertainty, such as the COVID-19 pandemic when households sought to safeguard against job losses and medical expenses.

Access to financial products also affects saving habits. High-yield savings accounts, certificates of deposit (CDs), and employer-sponsored retirement plans provide structured ways to accumulate wealth. Plans with matching contributions encourage long-term saving by offering immediate returns. Tax advantages further incentivize participation, with traditional IRAs allowing pre-tax contributions and Roth IRAs offering tax-free withdrawals in retirement. The SECURE 2.0 Act, which introduced automatic enrollment in employer retirement plans and higher catch-up contribution limits for older workers, illustrates how policy changes can influence saving behavior.

Psychological factors also shape saving decisions. Present bias leads individuals to prioritize immediate spending over future financial security, often resulting in inadequate retirement funds. Automatic savings mechanisms, such as payroll deductions or rounding-up transactions into savings accounts, help counteract this tendency. Studies show that automatic enrollment in workplace retirement plans significantly increases participation compared to opt-in systems.

Risk Tolerance

People’s willingness to take financial risks affects stock market participation, business investments, and capital allocation. Some embrace high-risk, high-reward decisions, while others prefer stability at the cost of lower returns. This variation influences asset prices, entrepreneurship, and corporate decision-making.

Market fluctuations test risk appetite. During economic expansions, investors take on more risk, driving up valuations in sectors like technology and speculative assets such as cryptocurrencies. In downturns, capital shifts toward safer investments like government bonds, gold, and dividend-paying stocks. The sharp decline in tech stocks in 2022, followed by a recovery fueled by artificial intelligence advancements, illustrates how sentiment swings impact investment choices.

Regulatory changes also shape risk-taking behavior. Stricter margin requirements limit leveraged trading by requiring investors to hold more capital to cover potential losses. Similarly, updates in accounting standards, such as ASC 326’s Current Expected Credit Loss (CECL) model, require financial institutions to recognize potential loan losses earlier, affecting credit availability and risk assessment. These rules influence how banks and businesses approach lending and investment decisions.

Time Preferences

How individuals and businesses value present versus future financial outcomes affects economic decision-making. Those who prioritize immediate benefits may rely on short-term financing, delay retirement contributions, or favor consumption over investment. Conversely, individuals with a long-term outlook are more likely to accumulate capital, plan for retirement, and invest in business expansion.

Businesses must balance short-term and long-term priorities when allocating capital. A company focused on immediate shareholder returns may prioritize stock buybacks or dividend payouts instead of reinvesting in research and development, potentially weakening long-term competitiveness. This is particularly relevant in industries requiring heavy upfront investment, such as pharmaceuticals and infrastructure. Accounting standards under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) further complicate these decisions, as depreciation schedules, impairment testing, and amortization methods affect how businesses report long-term investments.

Market Sentiment

Investor, business, and consumer confidence shape economic activity. Market sentiment influences asset prices, corporate investment decisions, and employment trends. When confidence is high, businesses expand, hire workers, and invest in new projects, while consumers are more willing to take on debt for major purchases. Pessimism, on the other hand, leads to reduced spending, lower stock valuations, and economic contraction.

Sentiment indicators, such as the Consumer Confidence Index (CCI) and the University of Michigan’s Consumer Sentiment Index, measure public perception of economic conditions. A decline in these metrics often signals reduced discretionary spending and increased savings, which can slow economic growth. The Volatility Index (VIX), known as the “fear gauge,” tracks expected stock market fluctuations. A rising VIX suggests uncertainty, prompting investors to shift toward defensive assets. The market downturn in early 2022, driven by inflation concerns and Federal Reserve tightening, demonstrated how sentiment can trigger widespread sell-offs even without immediate economic distress.

Corporate earnings reports and forward guidance also shape sentiment. When companies lower revenue projections, investors may interpret this as a sign of weakening demand, leading to stock price declines. The tech sector’s earnings revisions in 2023, particularly among semiconductor firms, reflected concerns over slowing global demand and tighter monetary policy. These shifts influence broader market trends, as sectors reliant on consumer and business confidence experience greater volatility.

Reaction to Policy Shifts

Government policies, including tax changes, interest rate adjustments, and regulatory reforms, influence economic behavior. Businesses and individuals adjust investment strategies, spending habits, and financial planning in response to new rules. The speed and magnitude of these reactions depend on the perceived impact of the policy, historical precedent, and market conditions at the time of implementation.

Tax policy changes affect corporate and individual financial decisions. When corporate tax rates decline, businesses may increase capital expenditures, expand operations, or engage in stock buybacks. The Tax Cuts and Jobs Act of 2017, which reduced the U.S. corporate tax rate from 35% to 21%, led to a surge in stock repurchases as firms returned capital to shareholders. On the individual side, adjustments to income tax brackets or deductions influence household budgets, affecting both consumption and savings rates. The expiration of enhanced child tax credits in 2022, for example, reduced disposable income for many families, impacting retail sales and consumer lending.

Monetary policy decisions, particularly interest rate changes, shape borrowing and investment behavior. When central banks raise rates, borrowing costs increase, leading to declines in mortgage applications, business loans, and corporate debt issuance. The Federal Reserve’s aggressive rate hikes in 2022 and 2023, aimed at curbing inflation, pushed mortgage rates above 7% for the first time in decades. This slowed home sales and increased demand for rentals, altering dynamics in the real estate sector.