Beyond Rationality: Unveiling the Role of Animal Spirits and Inflation Extrapolation in Central Bank Communication of the US

Abstract

Modern macroeconomic models, particularly those grounded in Rational Expectation Dynamic Stochastic General Equilibrium (DSGE), operate under the assumption of fully rational decision-making. This paper examines the impact of behavioral factors, particularly 'animal spirits' (emotional and psychological influences on economic decisions) and 'inflation extrapolators', on the communication index/sentiment index of the US Federal Reserve. Utilizing simulations from a behavioral New Keynesian model alongside real-world data derived from Federal Reserve speeches, the study employs an Auto-Regressive Distributed Lag (ARDL) technique to analyze the interplay between these factors. The findings indicate that while the fraction of inflation extrapolators do not significantly affect the Fed's sentiment index, various aspects of animal spirits exert a notable impact. This suggests that not only is the US output gap influenced by animal spirits, but the Federal Reserve's communication is also substantially shaped by these behavioral factors. This highlights the limitations of rational expectation DSGE models and underscores the importance of incorporating behavioral insights to achieve a more nuanced understanding of economic dynamics and central bank communication.