Uncertainty and Sentiment-Driven Equilibria

We construct a simple neoclassical model to capture the Keynesian idea that equilibrium aggregate supply is determined by aggregate demand and thus influenced by consumer sentiments about aggregate income. This result is nontrivial because in a standard neoclassical setting it is the aggregate supply (productive capacity) that determines aggregate demand, instead of the other way around, through factor-income shares and market-clearing mechanisms. However, we show that when firms’ production and employment decisions must be based on expectations of aggregate demand and that realized demand follows from firms’ production and employment decisions through market-clearing mechanisms, rational expectations about aggregate demand can lead to stochastic sentiment-driven equilibria despite the absence of production externalities, incomplete financial markets, strategic complementarity or any non-convexities in the model. The key is imperfect information arising naturally from the fact that production and employment decisions by firms, and consumption and labor supply decisions by households, are all made prior to goods being produced and exchanged, and before market clearing prices are realized. The sentiment-driven equilibria in our model are not based on randomizations over multiple fundamental equilibria as in many sunspot-driven business cycle models.