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Robust Animal Spirits

  • Matthew Smith

    (Federal Reserve Board of Governors)

  • Rhys Bidder

    (Federal Reserve Bank of San Francisco)

In a real business cycle model, an agent's fear of model misspecification interacts with stochastic volatility to induce time varying worst case scenarios. These time varying worst case scenarios capture a notion of animal spirits where the probability distributions used to evaluate decision rules and price assets do not necessarily reflect the fundamental characteristics of the economy. Households entertain a pessimistic view of the world and their pessimism varies with the overall level of volatility in the economy, implying an amplification of the effects of volatility shocks. By using perturbation methods and Monte Carlo techniques we extend the class of models analyzed with robust control methods to include the sort of nonlinear production-based DSGE models that are popular in academic research and policymaking practice.

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Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 265.

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Date of creation: 2013
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Handle: RePEc:red:sed013:265
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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