Confidence and the Propagation of Demand Shocks
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w27702.pdf
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Accepted version
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743.59 KB
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Author(s)
Angeletos, George-Marios
Lian, Chen
Date Issued
2022
Journal
Review of Economic Studies
Publisher
Oxford University Press (OUP)
Citation
Angeletos, George-Marios and Lian, Chen. 2022. "Confidence and the Propagation of Demand Shocks." Review of Economic Studies, 89 (3).
Version
Author's final manuscript
Abstract
Abstract
We revisit the question of why shifts in aggregate demand drive business cycles. Our theory combines intertemporal substitution in production with rational confusion, or bounded rationality, in consumption and investment. The first element allows aggregate supply to respond to shifts in aggregate demand without nominal rigidity. The second introduces a “confidence multiplier,” that is, a positive feedback loop between real economic activity, consumer expectations of permanent income, and investor expectations of returns. This mechanism amplifies the business-cycle fluctuations triggered by demand shocks (but not necessarily those triggered by supply shocks); it helps investment to comove with consumption; and it allows front-loaded fiscal stimuli to crowd in private spending.
We revisit the question of why shifts in aggregate demand drive business cycles. Our theory combines intertemporal substitution in production with rational confusion, or bounded rationality, in consumption and investment. The first element allows aggregate supply to respond to shifts in aggregate demand without nominal rigidity. The second introduces a “confidence multiplier,” that is, a positive feedback loop between real economic activity, consumer expectations of permanent income, and investor expectations of returns. This mechanism amplifies the business-cycle fluctuations triggered by demand shocks (but not necessarily those triggered by supply shocks); it helps investment to comove with consumption; and it allows front-loaded fiscal stimuli to crowd in private spending.
MIT Department
Massachusetts Institute of Technology. Department of Economics
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DOI of Published Version
https://doi.org/10.1093/RESTUD/RDAB064
