Working Paper: NBER ID: w27702
Authors: Georgemarios Angeletos; Chen Lian
Abstract: 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.
Keywords: aggregate demand; business cycles; confidence multiplier; fiscal policy
JEL Codes: E03; E10; E13; E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggregate demand shocks (E00) | business cycle fluctuations (E32) |
| negative aggregate demand shock (E00) | reduced utilization and labor demand (J29) |
| reduced utilization and labor demand (J29) | decrease in permanent income perception (D15) |
| decrease in permanent income perception (D15) | decreased spending (H56) |
| decreased spending (H56) | feedback loop amplifying demand shock (E32) |
| frontloaded fiscal stimuli (E62) | crowd in private spending (E20) |
| government spending (H59) | positive influence on consumer confidence (D12) |