ANIMAL SPIRITS AND ECONOMIC FLUCTUATIONS SHI FANG Adviser: Prof. Peter Matthews ECON 700 Senior Research

Introduction/Motivation  Animal Spirits and Economic Activity  John Maynard Keynes  Irrational human emotion or sentiments that are not the outcome “of a weighted average of quantitative benefits multiplied by quantitative probabilities.”  Irrational Confidence vs. Rational Confidence  Past recessions in the U.S.

Introduction/Motivation

Literature Review  Matsusaka and Sbordone (1995)  “Consumer Confidence and Economic Fluctuations.”  Self-fulfilling pessimism: an important independent factor in affecting aggregate output.  Chauvet and Guo (2003)  “Sunspots, Animal Spirits, and Economic Fluctuations.”  “Animal spirits” have played a nontrivial role in the , the , and the recessions.  Akerlof and Shiller (2009)  Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.  Homo economicus is an unrealistic notion. Emotions due to noneconomic motivations should be taken into account.

Data  Consumer Confidence  University of Michigan Consumer Sentiment Index  The Conference Board Consumer Confidence Index  Business Confidence  The Conference Board CEO Confidence Survey  Variables capturing economic fundamentals  Bureau of Economic Analysis (GDP, Personal Income, etc)  The Federal Reserve (Selected Interest Rates)  Moody’s Dismal Scientist

Data Summary  Time Series Sample Period  1976 Q Q1  132 Quarters  Selected Summary Statistics VariableMeanStd. Dev.MinMax Consumer(UM) Consumer(CB) Business Real GDP month TB

VAR Model where

VAR Model  Vector Autoregression  A n-equation, n-variable linear model in which each variable is in turn explained by its own lagged values, plus current and past values of the remaining n-1 variables.  Model Selection  Akaike's information criterion (AIC)  Schwarz's Bayesian information criterion (SBIC)  Hannan and Quinn information criterion (HQIC)  Autocorrelation  Stability condition

VAR Model  Best Specification (4-Variable with 4 Lags)  Consumer confidence (UM), business confidence, 3- month Treasury Bill interest rate, and first difference in log real GDP  Granger Causality Tests Dependent Variable in Regression RegressorConsumerBusinessGDPInterest Rate Consumer Business GDP ** ** Interest Rate ** 0.06 * 0.00 All ** 0.03 **

Results  Impulse Response Functions (IRF)  IRF trace out the response of current and future values of each of the variables to a one-unit increase in the current value of one of the VAR errors/innovations, assuming that this error returns to zero in subsequent periods and that all other errors are equal to zero.  Structurally interpretable IRF obtained by orthogonalized innovations via Cholesky decomposition  Order: GDP, Interest Rate, Business Confidence, Consumer Confidence

Impulse Response  Suppose that the VAR is stable, we can derive the vector moving- average representation of the VAR. where

Impulse Response

Conclusion  Animal spirits in business expectations has real, significant macroeconomic consequences.  Animal spirits in consumer sentiment, however, has a relatively less significant impact in affecting macroeconomic activities.  Limitations of the model due to Cholesky decomposition.

Questions/Discussions