The Effects of Investor Confidence Shocks on Business Cycles

This paper extends a quantitative medium-scale New-Keynesian DSGE model with financial intermediaries to account for shocks to investor confidence. Shocks of this nature manifest themselves as per period changes to financial intermediaries' leverage ratios. A Bayesian MCMC approach is utilized to estimate the base and extended model, including shock process parameters, for the U.S. economy using five macroeconomic time series from 1984 through 2019. The estimation results suggest that confidence shocks have a large and sustained effect on the real economy. Overconfidence initially provides a boost to the economy but this effect subsides and then triggers a prolonged recession. In the base model, a decomposition of U.S. output growth into its constituent shocks shows that the effect of negative shocks to capital quality contributed significantly to the financial crisis of 2008. However, this effect is muted in the extended model suggesting that shocks to confidence were important contributors to the output gap during the Great Recession