Replicating Business Cycles and Asset Returns with Sentiment and Low Risk Aversion

Abstract

This paper develops a real business cycle model with eight fundamental shocks and one “equity sentiment shock” that captures belief-driven fluctuations. I solve for the time series of shock realizations that allow the model to exactly replicate the observed time paths of U.S. macroeconomic variables and asset returns over the past six decades. The representative agent’s perception that movements in equity value are partly driven by sentiment is close to self-fulfilling. The model-identified sentiment shock is strongly correlated with other fundamental shocks and implies “pessimism” relative to fundamental equity value in steady state. Counterfactual scenarios show that the sentiment shock and shocks that appear in the law of motion for capital (representing financial frictions) have large impacts on the levels of macroeconomic variables and the size of the equity risk premium. Other shocks have large impacts on the growth rates of macroeconomic variables. Four of the model-identified shocks help to predict the equity risk premium or the bond term premium in the next quarter. Overall, the results support a narrative in which a large number of correlated shocks have combined to deliver the historical outcomes observed in U.S. data.