Research

Abstract: We embed confidence shocks in a DSGE model with households' heterogeneity and financial frictions. Confidence shocks are modeled as exogenous shifts in beliefs, unrelated to current and future economic fundamentals, that are able to generate waves of optimism and pessimism. The goal is to assess the role of confidence in explaining the boom-bust of credit and house prices in the United States prior and post financial crisis. Results from a Bayesian estimation of the model show that innovations to confidence account for half of the volatility of observed house prices, and can explain up to 40% of the 2000's housing boom. The results are consistent with the ones obtained by identifying confidence shocks in a structural VAR as exogenous innovations to the University of Michigan Sentiment Index. Our estimates indicate that there is a strong positive correlation between the confidence series filtered from the estimated DSGE model and the Sentiment Index, suggesting that the estimated belief shock in the DSGE model is indeed akin to confidence.

Abstract: This paper presents and solve a heterogeneous agent model à la Bewley with innovations to confidence. Confidence shocks are modeled as aggregate exogenous shifts in beliefs, unrelated to current and future economic fundamentals, that are able to generate waves of optimism and pessimism. First, I show that, by assuming GHH preferences, the labor supply response after a confidence shock can be derived in closed form, largely simplifying the computational burden of the solution algorithm. Second, a preliminary calibration of the model shows that belief shocks entail precautionary saving motives, which cannot be captured by a complete market representative agent version of the model. The paper concludes with further developments.