Working Paper: CEPR ID: DP14120
Authors: Gaetano Gaballo; Ryan Chahrour
Abstract: We provide a new theory of demand-driven business cycles based on learning from prices in an otherwise frictionless real model. In our model, house price increases caused by aggregate disturbances may be misinterpreted as a signal of improved local consumption prospects, leading households to demand more current consumption and housing. Higher demand reinforces the initial price increase in an amplification loop that drives comovement in output, labor, residential investment, and house prices even in response to aggregate supply shocks. The model's qualitative implications are consistent with observed business cycles, and it can explain apparently autonomous changes in sentiment without resorting to non-fundamental shocks.
Keywords: Demand shocks; House prices; Imperfect information; Animal spirits
JEL Codes: D82; D83; E03
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increases in house prices (R31) | Increased demand for current consumption (D12) |
| Increases in house prices (R31) | Increased demand for housing (R21) |
| Increased demand for current consumption (D12) | Reinforcement of initial price increase (D43) |
| Increased demand for housing (R21) | Reinforcement of initial price increase (D43) |
| Aggregate disturbances (E19) | Increases in house prices (R31) |
| Misinterpretation of house prices as improved local consumption prospects (D12) | Increased demand for current consumption (D12) |
| Misinterpretation of house prices as improved local consumption prospects (D12) | Increased demand for housing (R21) |
| Increases in house prices (R31) | Economic optimism (E66) |
| Economic optimism (E66) | Further increases in house prices (R31) |
| Aggregate supply shocks (E00) | Increases in house prices (R31) |
| House prices (R31) | Comovement in output, labor, residential investment, and other economic variables (E23) |
| Learning from prices mechanism (D41) | Demand-driven fluctuations (E32) |
| Learning from prices mechanism (D41) | Amplification of housing market fluctuations (R31) |