Selected Journal Publications

06.09.2017

How Sentiments Influence the Real Economy

Sentiments, financial markets, and macroeconomic fluctuations
BENHABIB, Jess | LIU, Xuewen | WANG, Pengfei
Journal of Financial Economics , 2016, 120 (2), 420 - 443

The financial sector plays a central role in the modern economy, as is evident from the wide and deep macroeconomic impact of the global financial crisis in 2007–2009. There are at least two channels through which the financial sector can influence the “real economy” -- the part concerned with producing goods and services -- namely the financing of capital, and the production of information about investment opportunities.

Jess Benhabib, Xuewen Liu and Pengfei Wang explored how the financial sector can affect the real economy through the information channel.  Unlike the conventional view that prices can help to efficiently allocate economic resources in a free market by signaling relevant information, they argued that the informational role of financial markets in allocating resources can be impaired by investors’ sentiments. The sentiment-driven asset prices in turn can influence real activities and shape macroeconomic fluctuations.

They formalized their idea in a simple baseline three-period model consisting of a continuum of investors and workers. The investors, who are the initial capital owners, live from period 0 to period 1. The workers live from period 1 to period 2. The only fundamental uncertainty in the economy is the total factor productivity (TFP -- the growth of output that cannot be explained by the growth of inputs such as labor) shock in period 2. They assumed, in the baseline case, that only the investors have information about the TFP shock. The shock directly affects the workers’ return on capital holdings in period 2, which are their labor income savings from period 1, and, hence, their incentive to supply labor in period 1. As capital and labor are complements in production, the workers’ labor supply in period 1 in turn affects the investors’ return on capital held from period 0 to period 1. In such an economic environment, the investors in period 0 need to forecast the level of employment and output in period 1. On the other side, forming expectations about the behavior of the investors, the workers can obtain information from the price of capital in period 0 about the return on their capital savings for period 2. This two-way interaction between the financial market and the real economy is at the heart of the researchers’ “mechanism of sentiments”.

In the model economy, “exuberant” financial market sentiments of high output and high demand for capital increase the price of capital, which signals strong fundamentals of the economy to the real side and consequently leads to an actual boom in output and employment. Suppose that these sentiments lead investors to believe there will be a boom in output. Then they conjecture that the demand for capital and, therefore, return on capital will be high. Competition in the financial market pushes up the capital price in period 0; however, the workers cannot tell whether the high price is due to investors’ sentiments or their signal of a high TFP in period 2. They attribute the high price partially to a high TFP. Their actual labor supply will indeed increase, resulting in a boom in output in period 2. So the investors’ initial belief will be confirmed.

Essentially, if investors perceive that the real side of the economy is affected by sentiments only for low fundamentals, their beliefs can become self-fulfilling under the two-way feedback. Due to the information feedback between the financial market and the real economy, investors’ perception of synchronization across countries can lead to actual synchronization. The model demonstrates that sentiment shocks can generate persistent output, employment and business cycle fluctuations, and it offers new implications for asset prices over business cycles. In the dynamic setting, the current savings of workers become the capital stock in the subsequent period. The capital stock, therefore, is dynamically linked across periods through savings. In the sentiment-driven equilibria, capital accumulation, as well as output and employment, is driven not only by the private future productivity signals received by investors, but also by their sentiments. Hence, sentiment shocks can generate persistent fluctuations in output and unemployment.


Comment

Try different words

THANK YOU

Thank you for your comments!