Economic Crises in a Model with Capital Scarcity and Self-Reflexive Confidence

TL;DR

This paper develops a behavioral business cycle model incorporating expectations and confidence, explaining how sudden drops in consumer confidence can lead to multiple economic crises with varying durations and suggesting policies to prevent prolonged downturns.

Contribution

It introduces a multiple equilibria model that captures demand and supply collapses driven by confidence swings, highlighting the impact of parameters on crisis duration and policy implications.

Findings

Multiple equilibria can lead to demand or supply crises.

Crisis duration can increase dramatically due to the 'paradox of thrift'.

Policy measures can prevent prolonged economic downturns.

Abstract

In the General Theory, Keynes remarked that the economy's state depends on expectations, and that these expectations can be subject to sudden swings. In this work, we develop a multiple equilibria behavioural business cycle model that can account for demand or supply collapses due to abrupt drops in consumer confidence, which affect both consumption propensity and investment. We show that, depending on the model parameters, four qualitatively different outcomes can emerge, characterised by the frequency of capital scarcity and/or demand crises. In the absence of policy measures, the duration of such crises can increase by orders of magnitude when parameters are varied, as a result of the "paradox of thrift". Our model suggests policy recommendations that prevent the economy from getting trapped in extended stretches of low output, low investment and high unemployment.