DP7743 | Expectation Shocks and Learning as Drivers of the Business Cycle

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14/03/2010

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Abstract

Psychological factors, market sentiments, and shifts in beliefs are believed by many to play a nontrivial role in inducing and amplifying economic fluctuations. Yet, these forces are rarely considered in macroeconomic models. This paper provides an attempt to evaluate the empirical role of expectational shocks on business cycle fluctuations. The paper relaxes the conventional assumption of rational expectations to exploit observed data on survey and market expectations in the estimation of a benchmark New Keynesian model. The observed expectations are modeled as formed from a near-rational expectation formation mechanism, which assumes that economic agents use a linear perceived law of motion for economic variables that has the same structural form as the model solution under rational expectations and that they need to learn model coefficients over time. In addition to the typical structural demand, supply, and policy disturbances, the model incorporates expectation shocks, which affect the formation of expectations by the private sector. Both the best-fitting learning process and the expectations shocks are identified from the expectations data and from the interaction between expectations and realized data. The expectations shocks capture waves of optimism and pessimism that lead agents to form forecasts that deviate from those implied by their learning model and by the state of the economy. The empirical results uncover a crucial role for these novel expectations shocks as a major driving force of the U.S. business cycle. Expectation shocks regarding future real activity are the main source of economic fluctuations, since they can account for roughly half of business cycle fluctuations.