Real business cycles, animal spirits, and stock market valuation

• Date: 01 March 2019
• Author: Kevin J. Lansing
• Published date: 01 March 2019
• DOI: http://doi.org/10.1111/ijet.12204

doi: 10.1111/ijet.12204

Real business cycles, animal spirits, and stock market

valuation

Kevin J. Lansing∗

This paper develops a real business cycle model with five types of fundamental shocks and one

“equity sentiment shock” that captures fluctuations driven by animal spirits. The representative

agent’sperception that movements in equity value are partly driven by sentiment turns out to be

close to self-fulfilling. I solvefor the sequences of shock realizations that allow the model to exactly

replicate the observed time paths of US consumption, investment, hours worked, the stock of

physical capital, capital’sshare of income, and the S&P 500 market value from 1960.Q1 onwards.

The model-identified sentiment shock is strongly correlated with survey-based measures of US

consumer sentiment. Counterfactual scenarios with the model suggest that the equity sentiment

shock has an important influence on the paths of most US macroeconomic variables.

Key wor ds belief-driven business cycle, excess volatility,animal spirit, sentiment, bubble

JEL classification E32, E44, O41

Accepted 1 August2018

Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street. When

you read contemporary accounts of booms or panics the one thing that strikes youmost forcibly

is how little either stock speculation or stock speculators to-day differ fromyesterday. The game

does not change and neither does human nature.

From the thinly disguised biography of legendary speculator Jesse Livermore, by E. Lef`

evre

(2006, p. 161, originally published in 1923).

1 Introduction

Theories about the interaction of sentiment and expectations have long played a role in efforts to

account for fluctuations in economic variables. Pigou (1927, p. 73) attributed fluctuations partly to

“psychological causes” which lead people to make “errors of undue optimism or undue pessimism

in their business forecasts.” Keynes (1936, p. 156) likened the stock market to a “beauty contest”

where participants devote their efforts not to judging the underlying concept of beauty, but instead

to “anticipating what average opinion expects the average opinion to be.” More recently, Ackerloff

∗Research Department, Federal Reserve Bank of San Francisco, San Francisco, California, USA. Email:

kevin.j.lansing@sf.frb.org

Thispaper began as a discussant presentation prepared for the May 15, 2015 Conference on Multiple Equilibria and Financial

Crisis, organized by JessBenhabib and Roger Farmer and hosted by the Federal Reserve Bank of San Francisco. For helpful

comments and suggestions, I thank Jang-TingGuo, an anonymous referee and participants at the 2018 Symposium of the

Society for Nonlinear Dynamics and Econometrics held in Tokyo, the 2018 CEGAP conference sponsored by Durham

UniversityBusiness School, and the 2018 California Macroeconomics Conference hosted by Claremont McKennaCollege.

Any opinions expressed here do not necessarily reflect the views of the Federal Reserve of Bank of San Francisco orthe

Board of Governors of the Federal Reserve System.

International Journal of Economic Theory 15 (2019) 77–94 © IAET 77

International Journal of Economic Theory

Stock market valuation Kevin J. Lansing

and Shiller (2009, p. 1) assert: “We will never really understand important economic events unless

we confront the fact that their causes are largely mental in nature.”

This paper develops a real business cycle model that incorporates the flavor of the above ideas.

The model has five types of fundamental shocks that influence labor productivity, labor disutility,

the marginal efficiency of investment, the cost of adjusting the capital stock, and capital’s share of

income. To capture the Keynesian notion of “animal spirits,” I allow for an “equity sentiment shock”

that is unconnected to fundamentals.

The representativeagent in the model makes use of a sentiment measure to construct a conditional

forecast involving future equity value. Due to the self-referential nature of the model, the agent’s

perception that movements in equity value are partly driven by sentiment turns out to be close to

self-fulfilling. The agent’s subjective forecast errors are close to white noise with near-zero mean,

giving no obvious signal that the sentiment-based forecast rule is misspecified.

I solve for the sequences of shock realizations that allow the model to exactly replicate the

observed time paths of US consumption, investment, hours worked, the stock of physical capital,

capital’s share of income, and the S&P 500 market value from 1960.Q1 through 2017.Q4. I show

that the model-identified sentiment shock is strongly correlated with survey-based measures of US

consumer sentiment. Counterfactual scenarios with the model suggest that the equity sentiment

shock has an important influence on the paths of most US macroeconomic variables.

There are a variety of ways in which animal spirits-type mechanisms can be incorporated into

quantitative business cycle models. The original contributions of Benhabib and Farmer (1994) and

Farmer and Guo (1994) exploit the indeterminacy of equilibrium (induced by increasing returns to

scale in production) to introduce “sunspot shocks” that give rise to belief-driven fluctuations under

rational expectations.1In a series of papers, Farmer (2012, 2013, 2015) introduces animal spirits via a

“belief function” that governs agents’expectations about future asset prices, which in turn, influence

the level of employment. The belief function serves to pin down a unique rational expectations

equilibrium in a framework that is otherwise missing a sufficient number of equilibrium conditions

relative to endogenous variables.

Animal spirits can also be introduced by means of “news shocks” that containnoisy signals about

future fundamentals. Agents’ expectations and decisions rationally incorporate the noisy signal, but

if the news later turns out to be wrong, it will appear as if the resulting fluctuations were not driven by

fundamentals.2Benhabib et al. (2015) show that rational sentiment-driven fluctuations can arise in

a model without externalities or non-convexities if firms make decisions based on expected demand

while households make decisions based on expected income. Milani (2010, 2017) introduces“expec-

tation shocks” in a New Keynesian model that cause the representative agent’s subjective forecasts to

deviate from the forecasts implied by an adaptive learning algorithm. Angeletos et al. (2018) intro-

duce animal spirits by means of “confidence shocks”that ar ise froman individual household’s belief

that their own signal about productivity is unbiased whereas others receive biased signals. The con-

fidence shock acts as wedge between an individual household’s subjective expectation and the fully

rational expectation that would prevail under complete information and common priors. Chahrour

and Ulbricht (2017) introduce “expectation wedges”that represent departures from full information

in an environment that is consistent with rational expectations of all agents. In the model developed

1These orginal models required very strong (and likely implausible) degrees of increasing returns to scale to generate

indeterminacy. But subsequent iterations introduced various mechanisms that could substantially reduce the required

degree of increasing returns for indeterminacy.See, for example, Wen (1998) and Guo and Lansing (2007).

2Chahrour and Jurado (2018) provide an overview of this literatureand discuss how the effects of pure shifts in beliefs can

be distinguished from changes in future fundamentals.

78 International Journal of Economic Theory 15 (2019) 77–94 © IAET