On the Propagation of Demand Shocks

This paper develops a novel theory of how a drop in consumer spending, or aggregate demand, can trigger a series of feedback loops between spending, employment, and income, ultimately leading to a sizable recession. Unlike the one embedded in the New Keynesian framework, our theory does not hinge on nominal rigidities and on the failure of monetary policy to replicate flexible prices. Instead, it is based on the idea that firms and consumers alike are unable to disentangle idiosyncratic from aggregate shocks and to reach common knowledge of the latter. This in turn could be either because of an information friction or because of bounded rationality. As a result, our theory bypasses the empirical failings of old and new Philips curves. It also allows for sizable fiscal multipliers without commensurate inflationary pressures.