Business cycles: torn between reason and passion?

By Dr. Fei ZHOU

It has been said by a political commentator that facts don’t care about your feelings. While this may well be true, can feelings – or sentiments – count as much as facts for firms trying to decide what they should do as the demand for their products changes? Sentiments and real business cycles ¹, a recent paper, seeks to answer this question by exploring whether individual firms react to sentiments as much as they do to facts despite being, as per economic theory, purely rational actors.

Many standard real business cycle (RBC) models predict that overall economic outcomes are entirely driven by changes in fundamental conditions. Thus, as firms encounter technological shocks such as the introduction of ChatGPT, they will – on aggregate – make accurate estimates about market demand and adjust their production accordingly, a situation dubbed traditional equilibrium. But what happens when firms only have incomplete information on demand (a state of affairs that seems intuitively more realistic)? Unable to differentiate the exact proportion of demand that is driven by fundamentals, the research suggests that optimistic managers will interpret favorable sentiments as equivalent – at least partly – to strong demand for their firm’s products. Excited about these developments, firms will increase production and investments. As total supply rises due to new capacity being added across the industry, selling prices eventually decline just as real wages surge, leading to even higher household consumption while bringing more idle individuals back to work. In such a sentiment-driven equilibrium model, waves of either pure optimism or unadulterated pessimism can thus trigger large fluctuations in the business cycles. So can sentiments drive business cycles or are business cycles purely rational?

It turns out that sentiments do matter! Using data from the US economy to study real business cycles across various scenarios, it appears that the volatility of output under the fundamental equilibrium is as much as 31% lower than that occurring under the sentiment-driven equilibrium. This is explained in part by the lack of information that producers of intermediate goods have about both the demand for their own products and the demand for final goods. Lacking a direct connection with consumers, they react mostly to the information embedded in the orders they receive from the producers of final goods. Prone to confuse market exuberance and/or gloom with fundamental changes in demand, they are thus vulnerable to adjusting production or making investments based on the market’s mood swings. The notion that such sentiment shocks can play an important role in amplifying fluctuations in real business cycles is further supported by the fact that labor market volatility under the sentiment-driven equilibrium is empirically more reasonable than that predicted by the fundamental equilibrium: more workers get hired quickly in the early stage of an optimistic boom, although the momentum dies quickly once the pendulum swings in the opposite direction. Reality always bites at the end!

Reference:

¹ Zhiwei X., Fei Z. & Jing Z. “Sentiments and real business cycles” Journal of Economic Dynamics & Control 141 (2022)