The Anatomy of Sentiment-Driven Fluctuations

Can a change in sentiment induce persistent macroeconomic fluctuations? Even though this idea has captured the minds of economists, it has been hard to formalize in models where economic agents have rational expectations.

Changes in sentiment of economic agents (e.g., producers and consumers), which are independent of macroeconomic fundamentals, can drive persistent macroeconomic fluctuations even when all agents have rational expectations. Changes in sentiment can not only drive economic fluctuations on their own but can also affect how other shocks affect macroeconomic outcomes.

We provide:

1. the necessary conditions under which changes in sentiment can affect aggregate outcomes.
2. the conditions under which changes in sentiment drive persistent fluctuations.

These conditions can help guide future theoretical and empirical work in better understanding these sentiment-driven macroeconomic fluctuations.