Sunspots, Animal Spirits, and Economic Fluctuations

Abstract

Multiple-equilibria macroeconomic models suggest that consumers and investors' perceptions about the state of the economy may be important independent factors for business cycles. In this paper, we examine empirically the interrelations between waves of optimism and pessimism and subsequent economic fluctuations. We focus on the behavior of non-fundamental movements in the consumer sentiment index, as a proxy for consumers' sunspots, and in the business formation index, representing investors' animal spirits, around economic turning points. We find that bearish consumers and entrepreneurs were present before the onset of some U.S. economic downturns, sometimes even when the fundamentals were all very strong. In particular, our analysis shows that self-fulfilling pessimism may have played a nontrivial role for the 1969-70, the 1973-75, and the 1981-82 recessions. The results are robust to a range of alternative linear and nonlinear specifications. Our evidence provides some empirical support for the role of non-fundamental rational expectations in economic fluctuations.

Keywords: Multiple Equilibria, Sunspots, Animal Spirits, Economic Fluctuations, Markov Switching Models

JEL Classification: C32, E32.