Confidence and the Propagation of Demand Shocks
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. The first element allows aggregate supply to respond to shifts in aggregate demand without nominal rigidity. The second introduces a “confidence multiplier,” namely 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 those triggered by supply shocks); it helps investment to comove with consumption; and it allows front-loaded fiscal stimuli to crowd in private spending.
This paper subsumes earlier versions that were entitled ”A (Real) Theory of the Keynesian Multiplier“ and ”On the Propagation of Demand Shocks“ and that contained somewhat different frameworks. For helpful comments and suggestions, We are grateful to the editor, Veronica Guerrieri, and three anonymous referees for extensive feedback that helped improve and reshape the paper. We also thank for useful comments Marty Eichenbaum, Susanto Basu, and seminar participants at NYU, MIT, FSU, the 2018 AEA meeting, the 2018 SED meeting, and the 2020 NBER Summer Institute. Angeletos acknowledges the financial support of the National Science Foundation (Award #1757198). Lian acknowledges the financial support from Alfred P. Sloan Foundation Pre-doctoral Fellowship in Behavioral Macroeconomics, awarded through the NBER. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.