Real business cycles, animal spirits, and stock market valuation

This paper develops a real business cycle model with five types of fundamental shocks and one “equity sentiment shock” that captures fluctuations driven by animal spirits. The representative agent's perception that movements in equity value are partly driven by sentiment turns out to be close to self‐fulfilling. I solve for the sequences of shock realizations that allow the model to exactly replicate the observed time paths of US consumption, investment, hours worked, the stock of physical capital, capital's share of income, and the S&P 500 market value from 1960.Q1 onwards. The model‐identified sentiment shock is strongly correlated with survey‐based measures of US consumer sentiment. Counterfactual scenarios with the model suggest that the equity sentiment shock has an important influence on the paths of most US macroeconomic variables.