Confidence and the Propagation of Demand Shocks

George-Marios Angeletos and Chen Lian

No 27702, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E03 E10 E13 E32 (search for similar items in EconPapers)
Date: 2020-08
New Economics Papers: this item is included in nep-mac
Note: EFG
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Citations: View citations in EconPapers (2)

Published as George-Marios Angeletos & Chen Lian, 2022. "Confidence and the Propagation of Demand Shocks," The Review of Economic Studies, vol 89(3), pages 1085-1119.

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