Endogenous Beliefs and Social Influence in a Simple Macroeconomic Framework

Abstract

This paper incorporates endogenously emerging beliefs, with an emphasis on the role of social influence, into a stylized Islands model, characterized by uncertainty and strategic complementarity generating frictional coordination. In particular, individuals can have pessimistic, neutral or optimistic beliefs and they can change these beliefs over time following a switching mechanism, driven both by economic outcomes and social influence. In such a framework, we study the emergent dynamics in order to assess the impact social influence has on agents' coordination, economic stability and welfare. We find that in the absence of social influence rational expectations are unstable and agents coordinate over time on a pessimistic and highly inefficient stationary state in which output and welfare are below the rational expectations equilibrium. As the importance of social influence grows, the steady state becomes even more pessimistic. As it crosses a certain threshold, additional equilibria emerge and the economy may converge to the rational expectations steady state, in which welfare is highest, or to a much more optimistic equilibrium, which is however not necessarily more efficient. We conclude that social influence can act as a coordination device able to smooth the impact of uncertainty and individual incentives, with positive effects on welfare.