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Sentiments: A Treatise on the Origins of Fluctuations

Jennifer La'O and George-Marios Angeletos ()
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Jennifer La'O: University of Chicago

No 1394, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: This paper develops a novel theory of the origins of fluctuations. This theory dispenses with the dubious notions of exogenous disturbances to technologies, preferences, or mysterious wedges. Instead, it points out the central role that self-fulfilling expectations can play in shaping short-run outcomes in \emph{any} decentralized economy---even when the equilibrium is unique. We consider a class of convex neoclassical economies in which agents are rational, the equilibrium is unique, there is no room for randomization devices, and there are no shocks to technologies, preferences, or other fundamentals. In short, we rule out all familiar sources of macroeconomic volatility. And yet, we show that these economies can be ridden with large and persistent fluctuations once one incorporates a simple but powerful insight: decentralization impedes communication. Standard DSGE modeling may fit these fluctuations by postulating exogenous shocks to preferences, technologies, or ``wedges''. Yet, these shocks would be, at best, obscure metaphors for a source of volatility that has been ruled out by the pertinent literature. Acute market observers may attribute this volatility to forces akin to ``animal spirits'', ``sunspots'', and ``irrational exuberance''. Yet, these ostensibly pathological phenomena are shown to be consistent, not only with rationality and equilibrium uniqueness, but also with a notion of constrained efficiency that may leave no room for stabilization policy.

Date: 2011
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