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The role of cognitive limitations and heterogeneous expectations for aggregate production and credit cycle

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  • de Grauwe, Paul
  • Gerba, Eddie

Abstract

The behavioural model of De Grauwe and Macchiarelli (2015) is extended to include financial frictions on the (aggregate) supply side. The result is a tight and sustained feedback loop between animal spirits on one hand, and supply of credit, capital purchase and production on the other. During phases of optimism, credit is abundant, access to production capital is easy, the cash-in-advance constraint is lax, risks are undervalued, and production is booming. Upon reversal in market sentiment, the contraction is quick and deep. Moreover, the model is capable of replicating the stylized fact of a long and sustained simultaneous growth in credit, production and asset prices observed in the US since mid1990’s. Lastly, the behavioural model does a decent job in matching US data including multiple supply-side relations including capital-firm credit and inflation-interest rate.

Suggested Citation

  • de Grauwe, Paul & Gerba, Eddie, 2018. "The role of cognitive limitations and heterogeneous expectations for aggregate production and credit cycle," LSE Research Online Documents on Economics 87942, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:87942
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    More about this item

    Keywords

    Supply-side; Beliefs; Financial frictions; Model validation;
    All these keywords.

    JEL classification:

    • B41 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Economic Methodology
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications

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