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 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.
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Copy CitationGeorge-Marios Angeletos and Chen Lian, "Confidence and the Propagation of Demand Shocks," NBER Working Paper 27702 (2020), https://doi.org/10.3386/w27702.Download Citation
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Published Versions
George-Marios Angeletos & Chen Lian, 2022. "Confidence and the Propagation of Demand Shocks," The Review of Economic Studies, vol 89(3), pages 1085-1119. citation courtesy of 
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