Animal spirits and credit cycles

In this paper we extend the behavioral macroeconomic model as proposed by De Grauwe (2012) to include a banking sector. The behavioral model takes the view that agents have limited cognitive abilities. As a result, it is “rational” to use simple forecasting rules and to subject the use of these rules to a fitness test. Agents are then driven to select the rule that performs best. The behavioral model produces endogenous and self-fulfilling movements of optimism and pessimism (animal spirits). Our main result is that the existence of banks intensifies these movements, creating a greater scope for booms and busts. Thus, banks do not create but amplify animal spirits. We find that increases in the equity ratios of banks tend to reduce the importance of animal spirits over the business cycle. The other policy conclusion we derive from our results is that the central bank has an important responsibility for stabilising output: output stabilization is an instrument to “tame the animal spirits”. This has the effect of improving the trade-off between inflation and output volatility.