Tuesday, May 19, 2015

Thought for the Day: Animal Spirits as a New Fundamental

 In IS-LM models there is always something in the background shifting the IS curve.  What is it?  

In my view that 'something' is Keynes' animal spirits that we should add to our models as a new fundamental.
In my work, I close my models by adding an equation that I call a 'belief function'. The belief function is an effective way of operationalizing the Old Keynesian assumption of ‘animal spirits’. It is a forecasting rule that explains how people use current information to predict the future. That rule replaces the classical assumption that the quantity of labor demanded is always equal to the quantity of labor supplied.
Here is a link to the blog I wrote on that topic last year.


  1. Dear Roger:

    While I can't claim to fully understand your models, I do think you're on to something crucial with animal spirits. A thought:

    Does this square the circle with some aspect of monetarism if M (the variously and vaguely defined so-called "money supply") is equated with household net worth?* (Which includes firms' net worth, as households are their ultimate owners.)

    By this thinking, greater animal spirits increase the money supply through runups in the equity (stocks and real-estate) markets.

    I think I've pointed out to you before: Every recession since the 60s has been preceded by a decline in Real Household Net Worth (with one bare false positive, a small decline in 2011).

    The corollary: Velocity of Wealth matters. This measure has been in secular decline since the 80s.

    Happy to provide links to Fred graphs on request.

    * Household total assets also has strong predictive value, from what I've found.

    As always, thanks for listening.

  2. Steve
    Yes - the net worth correlation is strong and causal (in the sense of Granger). In my view, it is independent of the MV = PT identity. Animal spirits shocks cause real net worth shocks which cause unemployment movements. Nominal income shocks are channeled into real net worth shocks or into inflationary expectation shocks by Fed policy.

  3. Roger: Thanks.

    Certainly PT is much less interesting, verging on useless, given its hopeless theoretical bases. (See: 1. those vexing hedonics and substitutions, and 2. the Cambridge Capital Controversy.) But still, the velocity of wealth strikes me as a construct that could be explored far more fruitfully.

    "Nominal income shocks are channeled into real net worth "

    If we talk Haig-Simons "income" (which includes market asset-value changes aka cap gains/losses), then (net) income is change in net worth. So nominal-income shocks are net-worth shocks. The national accounts' rather convoluted "income" measure -- and most economists' poor understanding of that measure -- obscure that view.

  4. I am not sure if this is the right place to share this thoughts, but this is related to my comments on a previous post about shifts in technology vs. animal spirits. A year ago, over wine and after too much BBQ at my house, Noah Smith and I were discussing what shifts beliefs. And we both agreed that maybe technological shits are the sunspots. It seems that many boom or busts have both a "real" component but also a "bubble" component. The productivity gains from the IT boom in the late 1990s are undeniable, but surely there was also an over-optimism in the ability of dot coms to generate profit. Similarly, the recent correction may have been an optimal response to the fact that the method of pricing and rating asset-based securities was flawed, but may this also lead to too much pessimism about what the "price" of those assets should be. In other words, these two factors, technology as broadly defined and animal spirits, may in fact work in tandem rather than be alternative explanations of the same phenomena. Anyway, just thought I should put this out there.

  5. Animal spirits should replace rational expectations in the equations. Rational expectations are mostly about knowledge of the present time, or of "eternal truths", i.e. inflation is what the central bank wants it to be. Animal spirits should also incorporate more experience of the past. Specifically, I believe that animal spirits are the expectation that not only current trends continue, but even the "trend of the trend" continues. And this belief gets stronger the longer the boom cycle continues. Right now, we're seeing a very long recovery, but the memory of the crash is still in people's minds so that it prevents euphoric animal spirits. As that memory falls away, speculation is going to re-emerge, so that, unless regulations are in place or a "well-timed" economic calamity occurs, the next bubble will be created.


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