Expectation Shocks and Learning as Drivers of the Business Cycle

Abstract

Psychological factors, market sentiments, and less-than-fully-rational shifts in beliefs are widely believed to play a role in the economy. Yet, they are rarely considered in macroeconomic models. This paper evaluates the empirical role of expectational shocks on business cycle fluctuations. The paper relaxes the rational expectations assumption to exploit survey data on expectations in the estimation of a New Keynesian model, which allows for learning by economic agents. Expectation shocks affect the formation of expectations and capture waves of optimism and pessimism that lead agents to form forecasts that deviate from those implied by their learning model. The empirical results uncover a crucial role for these novel expectations shocks as a major driving force of the U.S. business cycle. Expectation shocks regarding future real activity are the main source of economic fluctuations, accounting for roughly half of business cycle fluctuations.