Sentiments, Financial Markets, and Macroeconomic Fluctuations

Abstract

This paper studies how financial information frictions can generate sentiment-driven fluctuations in asset prices and self-fulfilling business cycles. In our model economy, exuberant financial market sentiments of high output and high demand for capital increase the price of capital, which signals strong fundamentals of the economy to the real side and consequently leads to an actual boom in real output and employment. In a two-country setting, our sentiment-driven fluctuations help explain global recessions and the cross-country comovement puzzles. In the extension to the dynamic OLG setting, our model demonstrates that sentiment shocks can generate persistent fluctuations in output and employment, holding the promise to explain persistent business cycle fluctuations.

Keywords: Sentiments, Asset Prices, Feedback, Real Economy, Self-fulfilling Equilibrium