Mood Swings and Business Cycles: Evidence from Sign Restrictions

Abstract

This paper provides new evidence that bouts of optimism and pessimism are an important source of U.S. business cycles, using the identification schemes based on sign restrictions. We document that identified optimism and pessimism shocks account for about 30% of U.S. business‐cycle fluctuations in hours and output. In addition, our empirical findings are consistent with the intensive‐ and extensive‐margin adjustments in the U.S. labor market over business cycles, providing further support to optimism shocks being an important source of U.S. business cycles. The identified optimism shocks are at least partially rational as total factor productivity is found to rise 8–12 quarters after an initial bout of optimism. While this later finding is consistent with some previous findings in the news shock literature, we cannot rule out that such episodes reflect self‐fulfilling beliefs.

Animal Spirits, Financial Markets, and Aggregate Instability

“…In sum, the estimation suggests that psychological motivations are behind a significant portion of the fluctuations in U.S. aggregate real economic activity. While the definitions of confidence shocks do not exactly overlap, this result parallels recent findings by Angeletos, Collard, and Dellas (2018), Milani (2017), and Nam and Wang (2018) who, while arguing within theoretical frameworks that involve uniqueness, also find that bouts of optimism and pessimism are driving a large fraction of U.S. aggregate fluctuations. For example, the confidence shock in Angeletos, Collard, and Dellas (2018) generates in excess of 50% of output's volatility.…”

“…Also related is Miao, Wang, and Xu (2015) who estimate a model with financial frictions and asset bubbles. Lastly, while the exact definitions of confidence do not completely overlap to the definitions used in the present paper, our result also parallels Angeletos, Collard, and Dellas (2018), Milani (2017), and Nam and Wang (2019) who maintain that sentiment swings drive a large fraction of U.S. aggregate fluctuations. 6 In Angeletos, Collard, and Dellas (2018), confidence shocks' contribution to business cycle volatility is more than 50%.…”

News Shocks, Business Cycles, and the Disinflation Puzzle

“…News about TFP, however, are clearly not the only factor that can cause changes in agents' expectations. Some recent studies have empirically examined the importance of changes in expectations caused by factors unrelated to TFP, such as news about investment‐specific technology (e.g., Ben Zeev and Khan 2015) or sentiments (e.g., Levchenko and Pandalai‐Nayar 2015, Fève and Guay 2019, Nam and Wang 2019). The identification of these shocks, however, usually relies on the prior identification of TFP surprise and/or news shocks, which implies that the empirical approaches developed in this strand of the literature are also likely to be plagued by measurement errors in TFP.…”

“…However, our focus and methodology differ from theirs. Nam and Wang (2019) are interested in identifying optimism shocks, which they define as nontechnological noninflationary disturbances that raise consumption and stock prices. To capture the noninflationary effect of these shocks, they impose a nonnegative response of the real interest rate.…”

Noise shocks and business cycle fluctuations in three major European Economies

“…2 The results of indicate that news shocks have a smaller role in explaining business cycle fluctuations, which contrasts with the findings of Beaudry and Portier (2006). In more recent work, Nam and Wang (2019) also use a larger VAR system but use sign restrictions to identify what they call 'optimism' shocks. Their results show that their optimism shocks resemble news shocks in the response they get from total factor productivity (TFP), consumption, investment and output.…”