The anatomy of sentiment-driven fluctuations

We show that sentiments - self-fulfilling changes in beliefs that are orthogonal to fundamentals - can drive persistent aggregate fluctuations under rational expectations in a beauty-contest game. Such fluctuations can occur even in the absence of exogenous aggregate fundamental shocks. Moreover, se...

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Bibliographic Details
Published in:Journal of economic theory 2021-07, Vol.195, p.105280, Article 105280
Main Authors: Acharya, Sushant, Benhabib, Jess, Huo, Zhen
Format: Article
Language:English
Subjects:
Dynamic signal extraction
Endogenous information
Sentiments
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Summary:We show that sentiments - self-fulfilling changes in beliefs that are orthogonal to fundamentals - can drive persistent aggregate fluctuations under rational expectations in a beauty-contest game. Such fluctuations can occur even in the absence of exogenous aggregate fundamental shocks. Moreover, sentiments alter the volatility and persistence of aggregate outcomes in response to fundamental shocks. We provide (i) necessary conditions under which sentiments can affect aggregate outcomes in equilibrium and (ii) conditions under which sentiments drive persistent fluctuations and when they only affect aggregate outcomes contemporaneously. We also show that sentiment equilibria are stable under least-squares learning while the fundamental equilibrium is not.
ISSN:0022-0531
1095-7235
DOI:10.1016/j.jet.2021.105280