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Confidence and the Propagation of Demand Shocks

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  • George-Marios Angeletos
  • Chen Lian

Abstract

We revisit the question of why shifts in aggregate demand drive business cycles. Our theory combines intertemporal substitution in production with rational confusion, or bounded rationality, in consumption and investment. The first element allows aggregate supply to respond to shifts in aggregate demand without nominal rigidity. The second introduces a “confidence multiplier,” that is, a positive feedback loop between real economic activity, consumer expectations of permanent income, and investor expectations of returns. This mechanism amplifies the business-cycle fluctuations triggered by demand shocks (but not necessarily those triggered by supply shocks); it helps investment to comove with consumption; and it allows front-loaded fiscal stimuli to crowd in private spending.

Suggested Citation

  • George-Marios Angeletos & Chen Lian, 2022. "Confidence and the Propagation of Demand Shocks," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(3), pages 1085-1119.
    • Handle: RePEc:oup:restud:v:89:y:2022:i:3:p:1085-1119.
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    File URL: http://hdl.handle.net/10.1093/restud/rdab064
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    Citations

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    Cited by:

    1. Kim, Hyeongwoo & Shao, Peng & Zhang, Shuwei, 2023. "Policy coordination and the effectiveness of fiscal stimulus," Journal of Macroeconomics, Elsevier, vol. 75(C).
    2. Xu, Xiangyun & Li, Xing & Meng, Jie & Hu, Xueqi & Ge, Yingfan, 2024. "The impact of the tail risk of demand on corporate investment: Evidence from Chinese manufacturing firms," Pacific-Basin Finance Journal, Elsevier, vol. 85(C).
    3. Yuemei Ji, 2023. "Shock Therapy in Transition Countries: A Behavioral Macroeconomic Approach," Comparative Economic Studies, Palgrave Macmillan;Association for Comparative Economic Studies, vol. 65(3), pages 483-510, September.

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