Expectations, Fluctuations, and Financial Intermediation

Expectations play a powerful role in the social sciences, particular in economics. Fluctuations in macroeconomic activity and asset markets are tied to aggregate shifts in market expectations. How confident economic agents look into the future has broad implications for macroeconomic fluctuations. As agents turn pessimistic, firms tend to decrease employment and investment due to lower demand and households reduce spending due to lower income prospects; a recession follows. Specifically, financial markets are strongly affected by shifts in beliefs. Yet, we know little on how autonomous changes in expectations affect the efficacy of the financial sector, financial market expectations, and eventually real macroeconomic outcomes. This research project Growth Expectations, Economic Fluctuations, and Financial Intermediation investigates the effect of market expectations on economic fluctuations. Two research papers are planned to answer questions around these issues. The first paper investigates how growth expectations affect economic fluctuations. If economic agents are overly optimistic, they over-estimate the current potential of the economy. This can yield adverse effects. The paper is particularly interested in beliefs at the tails of the distribution and investigates possible asymmetries. The second paper focuses on financial intermediation. Specifically, the paper investigates how optimism or pessimism about economic growth is intermediated through the financial system. The underlying idea is that the financial system propagates, accelerates, and magnifies sentiments. Therefore, economic fluctuations may be more volatile due to financial intermediation. These studies contribute to our understanding on how expectations affect economic outcomes and what the important transmission mechanisms are. In a next step, policy recommendations can be developed and proposed to mitigate detrimental outcomes.