Sentiments and Real Business Cycles

Abstract

We introduce sentiments under incomplete information into an otherwise standard real business cycle model. Individual firms receive signals about their idiosyncratic demand shocks which are confounded by sentiments. Sentiments coordinate optimal decisions of individuals through their extraction of the aggregate economic conditions from the signals. We show that there exists a sentiment-driven rational expectations equilibrium in addition to a fundamental equilibrium. Optimistic sentiments boost the aggregate economy, leading to positive comovements among output, consumption, investment, and hours worked. We calibrate a full-blown dynamic stochastic general equilibrium model based on U.S. aggregate data and find that sentiment shocks substantially amplify the aggregate fluctuations.