Quantifying Confidence

Abstract

We develop a tractable method for augmenting macroeconomic models with autonomous variation in higher-order beliefs. We use this to accommodate a certain type of waves of optimism and pessimism that can be interpreted as the product of frictional coordination and, unlike the one featured in the news literature, regards the short-term economic outlook rather than the medium-to long-run prospects. We show that this enrichment provides a parsimonious explanation of salient features of the data; it accounts for a significant fraction of the businesscycle volatility in estimated models that allow for various competing structural shocks; and it captures a type of fluctuations that have a Keynesian flavor but do not rely on nominal rigidities.

Wealth and Volatility

“…The representative firm's profits, which we denote ϕ t , can be interpreted as the returns to a fixed non-labor factor. 3 We will not model an explicit market for stocks, but simply assume that households collect profits at the end of the period.…”

What Drives Business Cycle Fluctuations: Aggregate or Idiosyncratic Uncertainty Shocks?

“…But it is plausible that smaller firms would be more significantly affected than larger firms under the second and third channels. Large firms tend to be more immune to bank credit rationing, given that they are better able to draw on internal equity, due to stronger balance sheets and liquidity positions, and also able to access the public equity and bond markets 3 , which are closed to small firms 4 .…”

“…2 Other innovations to the conventional approaches of modelling technology, preferences and policy shocks have been proposed recently. In particular, in a ground-breaking paper, Angeletos et al (2014) explore the role of variation in "confidence" about the state of the economy, finding it accounts for about one half of GDP uncertainty at business-cycle frequencies. paper which studies both shocks in tandem.…”

Experiments on Macroeconomics: Methods and Applications

“…These models seem to be particularly well-suited to describe behavior in generalized beauty-contest games and macroeconomic applications. 23 Angeletos, Collard, and Dellas (2015), García-Schmidt and Woodford (2015), Angeletos and Lian (2017), and Farhi and Werning (2017) incorporate level-k in monetary macro-models and assume heterogeneity with respect to agents' levels of reasoning. Woodford (2003) shows how inertia in higher-order beliefs (agents' beliefs about other agents' beliefs) can potentially be superior to sticky prices to reproduce aggregate inflation dynamics.…”