ASSET‐MARKET SENTIMENTS AND BUSINESS CYCLE FLUCTUATIONS

Abstract

We present a tractable model that accommodates asset‐market sentiment in a standard Dynamic Stochastic General Equilibrium (DSGE) setting, allowing us to quantitatively evaluate sentiment‐driven macroeconomic fluctuations. In our model, changes in households' perceived uncertainty about housing prices lead to self‐fulfilling fluctuations in housing prices, which then impact investment and output through entrepreneurs' collateral constraints. Household sentiment shocks hence are transmitted and propagated to the macroeconomy, generating boom–bust cycles. Uncertainty, housing prices, and the real economy are linked. Quantitatively, the sentiment shock in the form of risk–panic is a crucial driver of business cycle fluctuations despite the presence of various competing shocks.