The Impact of Expectations on Macroeconomic Instability

This dissertation investigates the impact of expectations on macroeconomic instability. In empirical macroeconomics, expectations are useful for the identification of structural effects. This is exemplified in different settings. First, for the identification of various monetary policy shocks from central banks. Second, for the identification of news coming from the credit market. The last setting builds upon the observation that market participants do make systematic errors in beliefs. Surprises in beliefs are used to identify a financial shock. Modeling approaches have to be adapted in order to identify structural shocks in the economy with the help of expectations and in a next step examine their influence on macroeconomic instability.
The first chapter investigates the international effects of Euro area rate forward guidance and compares them to spillovers from a conventional monetary policy shock. The forward guidance shock is identified via a combination of zero and sign restrictions that make use of the relationship between expectations and observed data. To address potential time variation, the proposed methodology uses a fully flexible approach that allows to handle both drifts in residual variances and the structural coefficients. The results show that both shocks lead to considerable international effects on output growth, inflation, and equity returns. Moreover, the investigation finds that effects are stronger during the period of the global financial crisis, which is particularly true for the forward guidance shock. This implies that monetary policy is generally not hindered in affecting the real economy by the zero lower bound. Additionally, shocks to expectations can have real domestic effects with international consequences.
The second chapter investigates the role of credit market sentiments and investor beliefs on credit cycle dynamics and their propagation to business cycle fluctuations. US data from 1968 to 2014 is used to show that credit market sentiments are indeed able to detect asymmetries in a small-scale macroeconomic model. By exploiting recent developments in behavioral finance on expectation formation in financial markets, an unexpected credit market news shock is identified which exhibits different impacts in an optimistic and pessimistic credit market environment. While an unexpected movement in the optimistic regime leads to a rather low to muted impact on output and credit, a significant and persistent negative impact on these variables is found in the pessimistic regime. Therefore, this chapter departs from the current literature on the role of financial frictions for explaining business cycle behavior in macroeconomics and argues in line with recent theoretical contributions on the relevance of expectation formation mechanisms as a source of macroeconomic instability.
The third chapter studies how non-rational risk shocks affect the macroeconomy. Exploiting survey data on expectations of financial executives, a non-rational risk shock is identified through belief dis- tortions. Surprises in beliefs in credit spreads measure belief distortions, and are used as a proxy for exogenous variation in the risk premium. Belief distortions elicit overreaction of credit spreads, even- tually leading to exaggerated beliefs on financial markets. Results indicate that the constructed shocks have statistically and economically meaningful effects. A positive non-rational risk shock moves credit spreads remarkably up while real activity and the stock market decline.