Monday, May 3, 2010

Expectation-driven business cycles

Are business cycles driven by expectations? Standard business cycle theory would tell you every depends on current fundamentals, but as expectations build on those fundamentals, both should matter. Take a real business cycle model. If people expect a total factor productivity shock to be persistent, they will adjust consumption and investment accordingly. But waht are the relative contributions of current fundamentals and expectations?

Sylvain Leduc and Keith Sill use various surveys on economic expectations and find they matter. That should not surprise too much, if one looks at the 1990 and 2008 recessions in the United States. But expectations are very hard to quantify, plus surveys have significant measurement issues. Still, their VAR gives a clear message.

This makes me wonder how much a business cycle can be "manipulated" by media and authorities. Think about the last crisis, where government and media were claiming we were slipping into the Great Depression. That could only be self-fulfilling. Or how Bush Jr. told Americans to consume after 9/11 to prevent a recession. Or the Soviets showing eternal optimism about their economy. But the latter could not be credible in the long run.

1 comment:

Joshua Hill said...

This research seems very familiar to that done by George Katona in the 1940's and 50's. Katona argued, probably based on his Gestalt psychology background, that the population's perception of the economy is very important in predicting future business cycle fluctuations. The Index of Consumer Sentiments eventually evolved out of this research. It is nice to see economists using contemporary methods to evaluate the importance of expectations.