Confidence and the Propagation of Demand Shocks

Abstract We revisit the question of why shifts in aggregate demand drive business cycles. Our theory combines intertemporal substitution production with rational confusion, or bounded rationality, consumption and investment. The first element allows supply to respond without nominal rigidity. second introduces a “confidence multiplier,” that is, positive feedback loop between real economic activity, consumer expectations permanent income, investor returns. This mechanism amplifies business-cycle fluctuations triggered by shocks (but not necessarily those shocks); it helps investment comove consumption; front-loaded fiscal stimuli crowd private spending.