Confidence and the Propagation of Demand Shocks

We revisit the question of why shifts in aggregate demand drive business cycles. Our theory combines intertemporal substitution in production with rational confusion (or bounded rationality) in consumption. The first element allows aggregate supply to respond to shifts in aggregate demand without nominal rigidity. The second introduces a “confidence multiplier,” namely a positive feedback loop between real economic activity, consumer expectations of permanent income, and investor expectations of returns. This mechanism amplifies the business-cycle fluctuations triggered by demand shocks (but not those triggered by supply shocks); it helps investment to comove with consumption; and it allows front-loaded fiscal stimuli to crowd in private spending.