Animal Spirits, Financial Markets, and Aggregate Instability

This paper examines whether people's animal spirits were drivers of U.S. business cycle fluctuations. In the context of an estimated macroeconomy with endogenous financial market frictions, allowing for “psychological” or nonfundamental expectational shocks improves the fit of the model and, at the posterior mode, these shocks account for well over one‐third of output fluctuations. Exogenous financial frictions are considerably less important. U.S. data favor the indeterminacy model over versions of the economy in which animal spirits cannot play a role.