Confidence collapse in a multihousehold, self-reflexive DSGE model

Federico Guglielmo Morelli, Michael Benzaquen, Marco Tarzia, Jean-Philippe Bouchaud
2020 Proceedings of the National Academy of Sciences of the United States of America  
We investigate a multihousehold dynamic stochastic general equilibrium (DSGE) model in which past aggregate consumption impacts the confidence, and therefore consumption propensity, of individual households. We find that such a minimal setup is extremely rich and leads to a variety of realistic output dynamics: high output with no crises; high output with increased volatility and deep, short-lived recessions; and alternation of high- and low-output states where a relatively mild drop in
more » ... ild drop in economic conditions can lead to a temporary confidence collapse and steep decline in economic activity. The crisis probability depends exponentially on the parameters of the model, which means that markets cannot efficiently price the associated risk premium. We conclude by stressing that within our framework, narratives become an important monetary policy tool that can help steer the economy back on track.
doi:10.1073/pnas.1912280117 pmid:32277025 fatcat:4kdokvse3vfjxoqnrayzatxh6u