Endogenous beliefs and social influence in a simple macroeconomic framework

Abstract

This paper incorporates endogenously emerging beliefs and social influence into a stylized Islands model characterized by uncertainty, strategic complementarity, and frictional coordination. Individuals in the model hold pessimistic, neutral, or optimistic beliefs, which can change over time due to economic outcomes and social influence. The study aims to assess how social influence affects agents’ coordination, economic stability, and welfare. We show that rational expectations are unstable in the absence of social influence. Agents coordinate over time on a pessimistic and highly inefficient stationary state in which output and welfare are below the rational expectations equilibrium. As the importance of social influence grows, the steady state becomes even more pessimistic. As it crosses a certain threshold, additional equilibria emerge. As a result, the economy may converge to the rational expectations steady state, in which welfare is highest, or to a much more optimistic equilibrium, which is not necessarily more efficient. Finally, we show that by reducing higher-order uncertainty, social influence can act as a coordination device with positive effects on welfare.