We formalize the Keynesian insight that aggregate demand driven by sentiments can generate output fluctuations under rational expectations. When production decisions must be made under imperfect information about demand, optimal decisions based on sentiments can generate stochastic self‐fulfilling rational expectations equilibria in standard economies without persistent informational frictions, externalities, nonconvexities, or strategic complementarities in production. The models we consider are deliberately simple, but could serve as benchmarks for more complicated equilibrium models with additional features.

We present an estimated dynamic stochastic general equilibrium model of stock market bubbles and business cycles using Bayesian methods. Bubbles emerge through a positive feedback loop mechanism supported by self‐fulfilling beliefs. We identify a sentiment shock that drives the movements of bubbles and is transmitted to the real economy through endogenous credit constraints. This shock explains most of the stock market fluctuations and sizable fractions of the variations in real quantities. It generates the comovement between stock prices and the real economy, and is the dominant force behind the internet bubbles and the Great Recession.

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