Seminar 18 November, 2013

Sentiment and the U.S. Business Cycle

Abstract:

Psychological factors are commonly believed to play a role on cyclical economic fluctuations, but they are typically omitted from state-of-the-art macroeconomic models.

This paper introduces ``sentiment" in a medium-scale DSGE model of the U.S. economy and tests the empirical contribution of sentiment shocks to business cycle fluctuations.

The assumption of rational expectations is relaxed. The paper exploits, instead, observed data on expectations in the estimation. The observed expectations are assumed to be formed from a near-rational learning model. Agents are endowed with a perceived law of motion that resembles the model solution under rational expectations, but they lack knowledge about the solution's reduced-form coefficients. They attempt to learn those coefficients over time using available time series at each point in the sample and updating their beliefs through constant-gain learning. In each period, however, they may form expectations that fall above or below those implied by the learning model. These deviations capture excesses of optimism and pessimism, which can be quite persistent and which are defined as sentiment in the model. Different sentiment shocks are identified in the empirical analysis: waves of undue optimism and pessimism may refer to expected future consumption, future investment, or future inflationary pressures.

The results show that exogenous variations in sentiment are responsible for a sizable (about forty percent) portion of historical U.S. business cycle fluctuations. Sentiment shocks related to investment decisions, which evoke Keynes' animal spirits, play the largest role. When the model is estimated imposing the rational expectations hypothesis, instead, the role of structural investment-specific and neutral technology shocks significantly expands to capture the omitted contribution of sentiment.

Contact: Battista Severgnini and Cédric Schneider