Do Optimists Grow Faster and Invest More?

Abstract

We discuss a two-period model of an economy with two industries, positive production externalities and random shocks to production functions. Multiple equilibria that arise in such a framework can be ranked according to agent's optimism. The equilibria with higher levels of optimism are characterized by higher economic growth, higher production growth and higher proportion of investments in externality yielding industries. Our model also suggests that time-varying risk perception and overconfidence level have impact on the industry and aggregate economic variables. Using the U.S. data, it is shown that changes in sentiment predict economic growth. Sentiment has significant positive impact on industry growth, aggregate economic growth and relative levels of investment in industries. Externality yielding industries also appear to be more affected by shifts in sentiment than non-externality yielding industries.

Keywords: Sentiment, Investment, Economic growth, Production externalities

JEL Classification: D92, G31, O16