ANIMAL SPIRITS AND ECONOMIC FLUCTUATIONS SHI FANG

1. ANIMAL SPIRITSAND ECONOMIC FLUCTUATIONSSHI FANG Adviser: Prof. Peter MatthewsECON 700 Senior Research

2. 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.

3. Introduction/Motivation

4. Introduction/Motivation

5. Introduction/Motivation

6. 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 1969-1970, the 1973-1975, and the 1981-1982 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.

7. 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

8. Data Summary • Time Series Sample Period • 1976 Q2 --- 2009 Q1 • 132 Quarters • Selected Summary Statistics

9. VAR Model where

10. 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

11. 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

12. 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

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

14. Impulse Response

15. Impulse Response

16. Impulse Response

17. Impulse Response

18. 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.

19. Questions/Discussions