Spotting sunspots: Some evidence in support of models with self-fulfilling prophecies

Abstract

This paper adds financial assests to Roger Farmer's business cycle model with increasing returns and self-fulfilling beliefs. By using information from the financial markets in conjunction with the structure of the model, we can uncover from financial data the belief shocks that drive the model. Specifically, we assume that belief shocks drive both economic fluctuations and asset returns. The financial market information allows us to identify these shocks. We use our methods to generate dynamic simulations of the model and show that it has incremental predictive power for key US time series.