Animal spirits and fiscal policy

De Grauwe, Paul and Foresti, Pasquale (2020) Animal spirits and fiscal policy. Journal of Economic Behavior & Organization, 171. 247 - 263. ISSN 0167-2681

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Abstract

In this paper, we study the effects of government spending with a behavioral macroeconomic model in which agents have limited cognitive capabilities and use simple heuristics to form their expectations. However, thanks to a learning mechanism, agents can revise their forecasting rule according to its performance. This feature produces endogenous and self-fulfilling waves of optimistic and pessimistic beliefs (animal spirits). This framework allows us to show that the short-run spending multiplier is state dependent. The multiplier is stronger under either extreme optimism or pessimism and reduces in periods of tranquility. Furthermore, the more the central bank focuses on output gap stabilization, the smaller the multiplier. We also show that periods of increasing public debt are characterized by intense pessimism, while intense optimism occurs in periods of decreasing debt. This allows us to show that governments face a trade-off between the stabilization of the animal spirits and the stabilization of public debt. Then, we show that the existence of this trade-off has implications also for the stabilization of the output gap.

Item Type:	Article
Official URL:	https://www.journals.elsevier.com/journal-of-econo...
Additional Information:	© 2020 Elsevier B.V.
Divisions:	European Institute
Subjects:	H Social Sciences > HB Economic Theory B Philosophy. Psychology. Religion > BF Psychology H Social Sciences > HJ Public Finance
JEL classification:	E - Macroeconomics and Monetary Economics > E1 - General Aggregative Models > E10 - General E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations; Cycles E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E62 - Fiscal Policy; Public Expenditures, Investment, and Finance; Taxation D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D83 - Search; Learning; Information and Knowledge; Communication; Belief
Date Deposited:	19 Feb 2020 14:00
Last Modified:	18 Oct 2024 17:27
URI:	http://eprints.lse.ac.uk/id/eprint/103500

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