Working Paper: CEPR ID: DP17087
Authors: Paul De Grauwe; Yuemei Ji
Abstract: We analyze how trust affects the transmission of negative demand and supply shocks. We define trust to have two dimensions: there is trust in the central bank’s inflation target and trust in the future of economic activity. We use a behavioural macroeconomic model that is characterized by the fact that individuals lack the cognitive ability to understand the underlying model and to know the distribution of the shocks that hit the economy. We find, first, that when large negative demand shocks occur the subsequent trajectories taken by output gap and inflation typically coalesce around a good and a bad trajectory. Second, these good and bad trajectories are correlated with movements in trust. In the bad trajectories trust collapses, in the good trajectories it is not affected. This feature is stronger when a negative supply shock occurs than in the case of a negative demand shock. Third, initial conditions (history) matters. Unfavorable initial conditions drive the economy into a bad trajectory, favorable initial conditions produce good trajectories.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large negative demand shocks (E00) | output gap and inflation trajectories (E31) |
| trust collapses in bad trajectories (E32) | output gap and inflation (E31) |
| trust remains stable in good trajectories (Z13) | output gap and inflation (E31) |
| unfavorable initial conditions (C62) | bad trajectories (P27) |
| favorable initial conditions (Y20) | good trajectories (P27) |
| trust in central bank (E58) | economic trajectories (P27) |
| optimism regarding future economic activity (E66) | economic trajectories (P27) |